What does the Gross Margin Reveal?

  • Jan 26, 2020 AEDT
  • Team Kalkine
What does the Gross Margin Reveal?

Gross Margin is calculated on gross profit divided by total sales and represented in terms of percentage. Gross profit is derived by deducting the cost of goods sold from total revenues. Within the cost of goods sold, a business reports its direct costs such as direct material and direct labor expenses related to the manufacturing of the products and/ or services as per the company’s business profile.

Depending upon the nature of the business, the cost of goods sold tends to vary due to the different direct costs such as those of materials procured, wage rates of labor engaged in the production process or consumables which are required directly in the production process . Under the direct expense relating to material and labor expenses, different companies report different kinds of expenses. For example, the direct expenses related to a real estate construction company would include raw materials and labor used for the construction purposes while direct expenses for a food and beverage company would be different and it would include direct expenses related with the cost of raw materials used for preparation of food. Moreover, the techniques applied for costing of these materials are likely to vary and so does the profitability depending on the nature of business. We will be discussing a few industries where we would be looking at various levels of gross margins based on the industry and its related expenses.

Gross Margin for Information Technology Companies: The direct costs related to the information technology (IT) companies are expenses related to the IT products i.e. hardware and software licenses or the costing of devices associated with the functioning of the business. Again, there are fees paid to the consultants who work to develop solutions and expenses related to the third-party contractors, marketing and selling expenses which are allocated proportionately for each product/service developed by the company. For example, cost of goods sold for 8Common Limited (ASX: 8CO)stood for FY19 stood at $1.065 million which represents a gross margin of 69.3%. In most of the cases, the Information Technology companies have lower cost of goods sold when compared as a percentage of revenue as compared to other industries. Thus, the gross margin for this sector remains relatively high as compared to the other sectors. Generally, a matured information technology company reports its gross margin within the range of 55% to 75% depending on the specialization of the business. Technology companies which are engaged in providing contract services have employee expense as the direct expense. So, the employee expense would be included in the cost of cost of goods sold, as employees contribute to the primary cost of operations. While several businesses which have a model of selling animation and 3D products will have research and development as the primary expense. Thus, in this this case, the expenses related to research and development should be considered as a component of direct expense.

Food Processing or Food Retail Segment: The cost of goods sold represents the raw material required for the processing of food and related products. For example, for a milk processing company, the raw material would be the raw milk while for a company which is engaged into the processing of pizza would consider flour, vegetables, spices and cooking materials as the direct costs or as cost of sales. For example, Coca-Cola Amatil Ltd (ASX: CCL), the direct costs would be water, sugar, carbonated materials etc. The gross margin of the CCL stands within a range of 39% to 42% as material costs are correlated to commodity prices. Similarly, as per industry averages, the median gross margin of the industry stood at ~42.2% during FY18. For example, Domino's Pizza Enterprises Ltd (ASX: DMP)reported a gross margin of 68.52% in FY19 as compared to the industry median of 55.4%. For a food processing company, the major costs with regard to direct expenses include cost of food, packaging materials and equipment expenses.

Mining and Exploration Segment: For mining and exploration businesses, the directs costs are related to the exploration and drilling activities along with the labor charges included with the operations. In most of the cases, the nature of the mineral deposit determines the costs related to the drilling and exploration activities. For example, Northern Star Resources Ltd (ASX: NST) derives a gross margin of 21.4% as compared to the industry median of 41.1% during FY19. Perenti Global Ltd (ASX: PRN), a mining and exploration company, has reported improved gross margin over the years. During FY17, the company’s gross margin stood at 25.5% while during FY18, the gross margin stood at 27.09% and in FY19, the same stood at 29.7%. Thus, we can conclude that the company has improved its methods of drilling which has resulted to improvement in the margins. Another important aspect of the mineral and resources business is that, the income of the business is directly co-related with the commodity prices prevailing in the market. Thus, the fixed costs remain at a certain level depending the volume of drilling activities, while the income tends to remain volatile as the commodity prices depend upon several macro and global factors. One of the pivotal characteristics of the sector is that, the volume of the commodities sold does not guarantee revenue growth all the time, while the pricing of the minerals does the trick in determining the income of the company.

Gross Margin for Retail Segment:  The direct costs related to the retail segment primarily consists of the rent associated with the shops or the outlets followed by the maintenance charges of the building etc. For example, the gross margin of the Super Retail Group Ltd (ASX: SUL) stands at 45.1% during FY19, higher than the industry median of 24.3%. JB Hi-Fi Ltd. (ASX: JBH) operates in computer retailing and derives 21.5% of gross margin from the business. Thus, SUL derives a higher gross margin than JBH due to the different nature of the businesses. SUL group is associated with the retail business of Automobile parts, tools and equipment related to boating, camping, outdoor equipment. The maintenance cost of the computer and hardware business is higher than the spare parts business because of the license and other software expenses associated with it. Due to the intangible expenses related to the computer software and hardware businesses, the costs are higher, resulting in lower than the industry median gross margin. While in case of retail businesses, owned properties do not have rent attached to them, suggesting a lower than average cost of sales. But on the other hand, the owned assets or plant and property of the businesses tend to be of higher value along with higher depreciation expenses. If the capital expenditures were funded by debt, then the interest costs are expected to be on the higher end, which are likely to hit the pre-tax margin.

In most of the cases, the gross margin fails to reveal the true potential of the business as the debt component cannot be tracked through gross margin. Capital-intensive businesses have high depreciation costs, which is also not reflected in the gross margin. High research and development expenses and higher employee expenses are an integral part of a business which are also not reflected through the gross margin. However, investors keep an eye on the gross margin as it indicates the price level of the raw materials and as well the pricing power of the business. In many cases, the business tries to market its products at premium prices despite the same quality of raw materials used for manufacturing the goods. The premium valuation of the finished goods is determined by the level of expertise that the company has towards the development of its products.

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