Gross margin ratio definition
/What is the Gross Margin Ratio?
The gross margin ratio is the proportion of each sales dollar remaining after a seller has accounted for the cost of the goods or services provided to a buyer. The gross margin can then be used to pay for administrative expenses as corporate salaries, marketing expenses, utilities, rent, and office supplies.
Understanding the Gross Margin Ratio
The managers of a business should maintain a close watch over the gross margin ratio, since even a small decline can signal a drop in the overall profits of the business. A further concern is that the costs that go into the calculation of net price can include some fixed costs, such as factory overhead. When this is the case, the gross profit margin will be quite small (or non-existent) when sales are low, since the fixed costs must be covered. As sales volume increases, the fixed cost component is fully covered, leaving more sales to flow through as profit. Thus, the gross margin ratio is more likely to be low when sales volume is low, and increases as a proportion of sales as the unit volume increases. This effect is less evident when the fixed cost component is quite low.
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How to Calculate the Gross Margin Ratio
To calculate the gross margin ratio, subtract the cost of goods sold from revenue in order to determine the gross margin, and then divide by net sales. The formula is as follows:
(Revenue - Cost of goods sold) / Net sales = Gross margin ratio
Example of the Gross Margin Ratio
A seller ships goods to a customer and bills the customer $10,000, while also charging the $3,000 cost of the shipped goods to expense. The result is a gross margin of $7,000, for which the gross margin ratio is:
$7,000 Gross profit ÷ $10,000 Net price = 70% Gross margin ratio
How to Increase the Gross Margin Ratio
It is essential to increase the gross margin ratio, since it is a key driver of the net profits generated by a business. We note below several options for improving the ratio.
Option 1. Redesign Products
A good long-term option is to redesign products so that they use less expensive parts or are less expensive to manufacture. The concept of target costing can be used to develop products that are designed to have specific margins. If a targeted margin cannot be achieved, then a product is not manufactured. Also, products can be designed to use common parts, so that volume discounts can be obtained from suppliers on these parts.
Option 2. Source Cheaper Parts
A good way to reduce costs is by finding less expensive suppliers, or concentrating purchases with fewer suppliers, thereby achieving volume discounts. Either approach reduces the unit cost of goods, and so increases the gross margin ratio. However, this can result in a decline in quality, so you need to be careful about monitoring the quality of incoming components.
Option 3. Increase Prices
It may be possible to selectively increase product prices. This is most likely when there are few other competitors from which customers can buy, and especially when supplies are tight. Prices might also be increased in exchange for quicker delivery times or a greater diversity in product offerings.
Terms Similar to the Gross Margin Ratio
The gross margin ratio is also known as the gross profit ratio.