Join Rudolph Rosenberg for an in-depth discussion in this video The basics of gross margin analysis, part of Financial Analysis: Analyzing the Bottom Line with Excel.
In this chapter we will be focusing on the analysis of gross margin. Gross margin is what is left over from your revenue once you have paid all the costs that relate to the production of goods. The more you get of it, the better for your business. To make it simple, the concept is that once a customer has paid for your product, you use that money to pay for all the elements that came into play for the production of your product such as raw material and the labor costs of producing the goods.
Of course in real life, you usually pay for those things before you sell them, so that means that you first have to spend the money, and then recover it as you sell your products. Most of the time, you actually buy the raw material in bulk and sell the products one at a time. So there's a bit of computation to be done. Let's imagine that you produce and sell pens. You then have to buy raw material to produce those pens, which in this case is plastic and ink to simplify.
Once those are bought they are delivered to your factory to be turned into pens. As the year goes on, you sell those pens and need to replenish your inventory, and therefore buy more plastic and ink. The prices of those raw materials changes every time you buy them. And since you don't wait to run out of raw materials to buy new ones, you end up producing pens from plastic and ink inventories that are a mixture of many purchases you have done at various prices.
So it could be tricky to know what is the real cost of producing your pens. Sometimes you will find great deals and make them at a lower cost of production. And sometimes you will buy them at a higher price. Plastic is a very good example, as most of the time it is made out of crude oil, and as the crude oil prices fluctuate you are very likely to buy it every time at a different price. We will see in this chapter first, how to gather the data points to calculate your gross margin, and then, most importantly, how to find out how profitable each sale is.
This will open the door to analyzing your business through the profitability angle and through different dimensions. In the day-to-day life of your business, you sell products and give discounts to your customers. And it is key for you to be able to make sure you are making good decisions on a day-to-day basis towards running a profitable business. We will do so by calculating the gross margin by product, which will allow us to calculate, in turn, gross margin by customer or any other dimension we're interested in.
Because we'll be talking specifically about gross margin analysis in this chapter, if at any point you feel like you want more information on gross margin in general you can learn more about it in the course Financial Literacy: Reading Financial Reports in the Lynda.com training library.
Also check out the companion course, Financial Analysis: Analyzing the Top Line with Excel.
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- Finding data points
- Prepping data
- Calculating standard cost and gross margins
- Analyzing overall gross margin performance
- Analyzing individual and overall expenses