Gross Margin Ratio Definition, Formula and Example
Gross Margin Ratio Definition – Gross profit as a percentage of revenue.
This is another type of profitability ratios that compares the gross margin with that of net sales. In other words, it shows the business efficiency to clear off its inventory. This is the part of profit that company has earned after selling out its inventory.
Do not use gross margin and profit margin interchangeable as both the terms are very different from each other. Profit margin is a bigger concept as it considers all the expenses whereas gross margin only considers COGS.
Gross Margin Ratio = Gross Margin/Net Sales
Where gross margin is Net sales minus cost of goods sold. On the other hand net sales is gross sales minus refunds or returns.
Gross Margin Example
Let’s understand the gross margin definition with the help of an example. ABC company spent 2,00,000 in the inventory. The organisation is able to sell inventory of Rs. 5,00,000. However, due to defective product, 70,000 of the goods are returned. Calculate the gross margin ratio for the given company.
Gross Margin = (4,30,000 – 2,00,000)/ (5,00,000 – 70,000) ×100
= (2,30,000 / 4,30,000) ×100
= 0.5 × 100
This implies that even if the company pays off the inventory cost, it still has 50 percent of the sales revenue with itself in order smoothly conduct the day to day operations.
Interpretation of Gross Margin Ratio
This ratios analyzes how efficiently the business is managing the inventory. A higher gross margin ratio is favorable for the business. This indicates that company is selling off the inventory at higher profit rate. It can be achieved, if the cost of buying inventory is very less. Now the company can sell it at higher profits even if it provides the discount to the customers.
Secondly, the management can increase the price of the goods. However this will make the goods expensive. Competition is very high so this type of strategy could also back fire. This ratio not only shows the efficiency in clearing off the inventory but also measures the percentage of sales that can be used for funding other things.