Reading time: approx. 5min
There are many different financial ratios that can be calculated from a company's balance sheet. One key figure that has become indispensable for me is the return on capital employed (ROCE). This can be calculated using various entries from the balance sheet and is a measure of how efficiently a company can use invested capital to generate profits.
However, this article will focus on a much simpler key figure: the gross margin. In German-speaking countries, the gross margin is better known as the gross margin known as the gross margin. It indicates the proportion of sales after deducting direct production costs or manufacturing costs - the so-called cost of revenues - remains.
Example: the company Pomme generates $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%.
In this example, the $400 is the gross profit or the gross profit. The gross margin is a very simple key figure and can also be interpreted wonderfully: the company Pomme manufactures its products (proportionately) for 6$ and sells them to customers for 10$. 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, production costs, raw material costs, energy costs and labor costs. However, it does not include costs incurred for the sale or distribution of the product. These costs are reported under selling, general and administrative 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 a further $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 for every $1,000 in sales, the company retains around $260 as profit (before tax). 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 of a company's pricing power. In this article, however, we are focusing on a different aspect: a company's resilience to inflation. This is where the gross margin plays a decisive role.
Two fairly 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 an EBIT margin of thirty percent and are therefore highly profitable companies. However, if we turn our attention to the gross margin, it is striking: Apple has a gross margin of 70% while pear has a gross margin of 45%. This doesn't seem to matter at first, because in the end both companies generate a profit of $300 from $1,000 in sales.
In a phase of high inflation, however, not all of a company's costs rise equally. In particular, the cost of revenues, which includes production costs, labor costs, raw material costs and energy costs, will rise roughly in line with the inflation rate, whereas the other cost items are not subject to inflation to the same extent.
In this example, we assume an annualized inflation of 8% annualized inflation. In the hypothetical scenario, we assume that the other expenses do not change in percentage terms. What do the balance sheets of the two companies look like after inflation?
Company Apple
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 has fallen from 30% to 27.6% due to inflation. This corresponds to a fall in profit of 8%. The situation is quite different for Pear the operating margin has fallen from 30% to 25.6%. A decline of around 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 absorb a fall in profits of just under 15%, all other things being equal. In order to avoid a fall in profits Pears would have to increase prices by 15%, whereas Apple would only have to increase prices by 8%.
If both companies are direct competitors, the situation is even more paradoxical: Apple probably has high pricing power anyway with its high gross margin and only has to increase prices by 8% to compensate for the increased production costs. In contrast, the competitor Pears would have to increase its prices by a full 15% to achieve the same effect. Either Pears decides to increase its prices by 15% and has to accept that some customers will switch to 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 in exactly the same way. However, it is also not an academically constructed example and this effect can indeed be observed in companies: while LVMH ($MC (+0.4%)) was able to keep its gross margin constant at around 68% from 2021 to 2022, Target's ($TGT (-2.56%)), the gross margin fell from around 29% to around 24%, driven by the higher cost of revenues. In the same period, Target's profit fell by around 14% with a slight increase in sales.
