Analyzing Comparative Financials for the Gross Margin

A business is always trying to improve its financial situation by engaging in financial analysis and planning. A common method that businesses use to analyze their financial situations involves drafting and evaluating comparative financial statements, and one of the most important entries on a comparative financial statement is the gross margin.

About the Gross Margin

The gross margin represents the proportion of a business's net sales that are profit during an accounting period. The gross margin does not account for any other business expenses. To calculate the gross margin for a business, determine the total revenue the business earned during the accounting period and subtract the cost of the goods the business sold during that same period. Divide the result by the total of the business's net sales for that accounting period to get the ratio, or percentage, that represents gross margin.

Comparing Gross Margins

Comparative financial statements usually list the gross margins from the accounting periods you are comparing in separate columns on the same line of the report. If your gross margin increases, comparative analysis indicates that your business is earning a higher profit or that there has been an accounting error. On the other hand, if your gross margin decreases, comparative analysis indicates that your business's profit is decreasing or that there has been an accounting error. Ideally, your business's gross margin should increase or remain the same from one accounting period to the next.

Interpretations of Lower Margins

Gross margins may decrease if you changed the sale prices of your products without decreasing the cost of producing them. Gross margins may also decrease if your volume of sales decreased, if management made bad purchasing decisions or if an employee excluded some of the company's sales from your accounts. Finally, if the cost of producing the goods you sold increased but you did not increase the price, your profit margins may decrease.


Interpretations of Higher Margins

Gross margins may increase if you raised the selling price of your goods but the price of producing them remained the same. It may also increase if the cost of producing your products decreased but you didn't lower your selling prices. If your gross margins increased because of an accounting error, it is possible that an employee omitted some of your purchase invoices from your accounts.

Making Changes

After you determine the source of a gross margin decrease, you can change the way your business operates to rectify it. For example, if your profit margin decreased because the cost of producing goods increased, you can raise the prices on your products to solve the problem. Likewise, if your profit margin decreased because you lowered your prices, you can either raise them again or try to lower the cost of producing your products. If you determine that an accounting error is responsible for an increase or decrease, you can strengthen your company's accounting practices to prevent the error from recurring.