Gross margin is calculated as “[Gross Profit/Revenue] multiply by 100.”
It helps businesses to measure how much money is left to devote to sales people, advertising, rent, utility bills, etc.
If gross margin is too small, then the company can renegotiate contracts with third-parties or raise prices.
But, how do you know what is too small or too big and how do we measure it?
This varies between sector by sector. For example, the airline industry has gross margins of a few percent because fuel costs and aircraft purchases are high. Whereas, the software industry has gross margins as high as 90% because most of the costs come from hiring talents.
Benefit of gross margins
One benefit is the gross margin isn’t influenced by exceptional charges or impairment charges that would distort net profit. That’s important because you want to understand the weakness in the business without seeing it go overboard!
Walbrock’s Investing Tip: For the retail sector and others, you can measure the value of inventory with gross profit.
One equation is to use the Gross Margin Return on Investment (GMROI). That is “[Gross Profit/Average Inventory Costs], then multiply by 100].”
If GMROI is 150%, then it means the company can sell inventories at 1.5 times the cost.
If GMROI is 25%, then the company is selling at a quarter of the costs meaning they will make a loss.
Oh, in case I forgot it’s gross profit margin is not profit!
Investopedia; – http://www.investopedia.com/terms/g/grossmargin.asp
Accounting Coach; – https://www.accountingcoach.com/blog/what-is-gross-margin (With related Q&A)
Financial Wisdom; – http://www.financialwisdom.com/smbusresourcecenter/Sample/Calculators/GrossMargin.shtml (It has a gross margin calculator)
Investopedia; – http://www.investopedia.com/terms/g/gmroi.asp (Using gross margin to value inventory)