The importance of gross margin in times of high inflation
Reading time: approx. 5min
There are many different financial ratios that can be calculated from a company's balance sheet. One metric that has become indispensable to me is Return on Capital Employed (ROCE). This can be calculated through various entries from the balance sheet and is a measure of how efficiently a company can use invested capital to generate profits.
In this article, however, we will focus on a much simpler indicator: the gross margin. In German-speaking countries, the gross margin is better known as the gross margin is better known. It indicates the proportion of sales which, after deduction of direct production costs or manufacturing costs - the so-called cost of revenues - remains.
Example: the company Pomme achieves $1,000 in sales and has to pay $600 in production costs. The gross margin is then
(1.000$ - 600$) / 1.000$ = 400$ / 1.000$ = 40%.
The 400$ in this example is the Gross Profit or the gross profit. The Gross Margin is a very simple ratio and can also be interpreted in a wonderful way: the company Pomme manufactures its products (proportionally) for 6$ and sells them for 10$ to the customers. The higher the margin between production costs and sales revenue, the more lucrative the business model.
However, the gross margin is not yet the profit margin of a company. In the cost of revenues includes, for example, manufacturing costs, raw material costs, energy costs and labor costs. However, no costs incurred for the sale or distribution of the product. The costs are reported under selling, general and administraive expenses (SG&A) in the balance sheet. Research and development expenses - i.e. research and development expenses (R&D) - are not yet included in the gross margin.
The company Pomme from the above example now has costs of $70 for the sale and distribution of its products and spends another $70 on research and development. If we subtract this from the gross profit, we get the so-called operating income:
Revenue
-
Cost of Revenue
=
Gross Profit
-
Selling, General & Administrative Expenses
-
Research & Development Expenses
=
Operating Income (=EBIT)
For Pomme it looks like this in percentage terms:
100% Revenue
- 60% Cost of Revenues
=
40% Gross Margin
- 7% SG&A
- 7% R&D
=
26% Operating Income Margin
This is still not the actual profit, because, as you know, taxes still have to be paid on profits. However, we will no longer take this into account and will only look at operating income. In the case of Pomme this means that of $1,000 in sales, about $260 remains as profit (before taxes) for the company. The higher the operating income margin, the more profitable a company is.
However, this article is not about the operating income margin but about the gross margin. The size of the gross margin can be an indicator for the pricing power of a company. In this article, however, we will focus on another aspect: a company's resistance to inflation. Here, gross margin plays a crucial role.
Two pretty much identical companies?
Let's look at two companies Apple and Pear. We break down their costs as a percentage of sales:
Company Apple
100% Revenue
- 30% Cost of Revenues
=
70% Gross Margin
- 25% SG&A
- 15% R&D
=
30% Operating Income Margin
Company Pear
100% Revenue
- 55% Cost of Revenues
=
45% Gross Margin
- 10% SG&A
- 5% R&D
=
30% Operating Income Margin
Both companies have a thirty percent EBIT margin and are therefore highly profitable companies. However, if we focus our attention on the gross margin, we will notice: Apple has a gross margin of 70% while Pear has a gross margin of 45%. This seems to be irrelevant at first, because in the end both companies achieve a profit of $300 from $1,000 in sales.
However, in a period of high inflation, not all costs of a company increase equally. In particular the cost of revenueswhich includes manufacturing costs, labor costs, raw material costs and energy costs, will increase roughly in line with inflation, whereas the other cost items are not subject to inflation to the same extent.
In this example, we assume an annualized inflation of 8% is assumed. We assume in the hypothetical scenario that other expenses do not change in percentage terms. What do the balance sheets of the two companies look like after inflation?
Apple company
100% Revenue
- 32.4% Cost of Revenue (+2,4%8% inflation)
=
67.6% Gross Margin
- 25% SG&A
- 15% R&D
=
27.6% Operating Income Margin
Company Pear
100% Revenue
- 59.4% Cost of Revenue (+4,4%8% inflation)
=
40.6% Gross Margin
- 10% SG&A
- 5% R&D
=
25.6% Operating Income Margin
The operating margin of Apple fell from 30% to 27.6% due to inflation. This corresponds to a profit decrease of 8%. The situation is quite different for Pear the operating margin fell from 30% to 25.6%. A decrease of about 15%!
So although both companies are subject to the same inflation rate of 8%, the company with the lower gross margin is hit harder and would have to cope with a drop in profits of just under 15% - all other things being equal. To avoid a drop in profits would have to be Pear would have to increase prices by 15%, whereas Apple would only have to increase prices by 8%.
If both companies are direct competitors, it is even more paradoxical: Apple with its high gross margin probably has a high pricing power anyway and only has to increase prices by 8% to compensate for the increased production costs. In contrast, the competitor Pear would have to increase its prices by a full 15% to achieve the same effect. Either Pear decides to increase its prices by 15% and has to accept that some customers will switch to apple. Apple or the increased production costs cannot be passed on directly to the customer, which reduces future profits.
Summary
The above is of course an idealized example which probably does not occur in practice. However, it is also not an academically constructed example and this effect can indeed be observed in companies: while LVMH ($MC) was able to keep its gross margin constant at around 68% from 2021 to 2022, Target ($TGT) saw its gross margin drop from around 29% to around 24%, driven by the higher cost of revenues. In the same period, Target's profits also declined by around 14% on slightly higher sales.
