# Income Statement Analysis: Gross Margin

The Gross margin is one of the first margins we can find on the Income Statement. The Gross margin is shown in percentage and it will give us a good indication of the performance of the core activity of a company. The formula to calculate the Gross margin goes as follows:

Gross margin (%) = Gross profit / Total revenue

Before we take a look at the interpretation of the Gross margin we first have to understand the concept of Gross profit. We can find the Gross profit after deducting the cost of goods sold from total revenue.

Gross profit = Total revenue - Cost of goods sold
with Revenue = Price x Quantity

In analyzing revenue we have to analyse both components:
• Price: pricing power
• Quantity: market share, macro economic environment

The Cost of goods sold (COGS) are the direct costs we have to make to generate revenue. In a retail environment like for AD the purchase of the products are an important component of the cost of goods sold. In most cases the cost of goods sold are variable costs. Which means that those costs will fluctuate with a change in output.

Now that we have a better understanding of the Gross profit, we will continue with the interpretation of the Gross margin. To calculate a margin in the Income Statement we often divide a profit result by Total revenue. I will repeat the formula for the Gross margin (%): Gross margin = Gross profit / Total revenue
The Gross margin can increase in the following ways:
• An increase in Gross profit: this can be the result of an increase in revenue or cost optimization (decrease in cost of goods sold)
• Decrease in Total revenue: pay attention because a decrease in Total revenue also means a decrease in Gross profit
• Gross profit increase > Total revenue increase
• Total revenue decrease > Gross profit decrease
It is very important to take a deeper look into the source of the increase in the Gross margin. The growth rate of the revenue versus the growth rate of the cost of goods sold plays an important role here. If revenue grows faster than the cost of goods sold the portion of the COGS in % to total revenue will lower. As a result the Gross profit as percentage of Total revenue will increase (increase in Gross margin).

Example: Inflation has less consequences on the Gross margin of a company with pricing power, because the company can increase its price which will result in higher revenue to compensate for the increase in cost of goods sold.

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