Gross margin

6.1 Analysis and Interpretation – Gross‑Margin (Cambridge IGCSE Accounting 0452)

Link to the Syllabus

This note satisfies syllabus section 6.1 – Gross‑margin. It addresses the required content for the Analysis and Interpretation objective (AO2) and provides material for the Evaluation objective (AO3) such as interpretation, inter‑firm comparison, identification of interested parties and suggested actions.

1. Definition

• Gross‑margin (also called gross‑profit margin) is the proportion of sales revenue that remains after deducting the cost of goods sold (COGS). It shows how efficiently a business converts its inventory (or direct service costs) into profit before any overheads, interest or tax.

2. Formula

\[ \text{Gross‑Margin (\%)} = \frac{\text{Gross Profit}}{\text{Sales Revenue}} \times 100 \] \[ \text{where } \text{Gross Profit} = \text{Sales Revenue} - \text{COGS} \]

3. Where the Figures Come From

Both numbers are taken from the profit & loss account (or the trial balance).

• Sales Revenue (Turnover) – total amount earned from selling goods or services during the period.
• Cost of Goods Sold (COGS) – the total cost of the inventory (or direct service inputs) that has been sold.

3.1 COGS for a Trading/Manufacturing Business

\[ \text{COGS}= \text{Opening Stock} + \text{Purchases} + \text{Purchase Returns (negative)} + \text{Freight‑in} + \text{Direct Expenses} - \text{Closing Stock} \]

3.2 COGS for a Service‑Oriented Business

• Service firms usually have little or no inventory. In this case, COGS is the total of direct costs incurred to deliver the service (e.g., staff salaries, subcontractor fees, materials used).
• Overheads such as rent, administration and marketing are **not** included in COGS.

3.3 COGS for a Club or Society

• Clubs often have no sales revenue. The equivalent ratio is the contribution margin expressed as a proportion of total receipts (membership fees, event income, etc.).
• Use the same formula, substituting “total receipts” for sales revenue and “direct costs of the activity” for COGS.

4. Step‑by‑Step Calculation (Trading Business)

1. Obtain Sales Revenue for the period.
2. Calculate COGS using the appropriate formula (trading, service or club).
3. Determine Gross Profit: \[ \text{Gross Profit}= \text{Sales Revenue} - \text{COGS} \]
4. Compute the Gross‑Margin %: \[ \text{Gross‑Margin (\%)} = \frac{\text{Gross Profit}}{\text{Sales Revenue}} \times 100 \]

5. Worked Examples

5.1 Trading Business Example (ABC Ltd.)

Item	Amount (£)
Sales Revenue	120,000
Opening Stock	15,000
Purchases	70,000
Closing Stock	10,000

Step 1 – COGS

\[ \text{COGS}=15,000 + 70,000 - 10,000 = 75,000 \]

Step 2 – Gross Profit

\[ \text{Gross Profit}=120,000 - 75,000 = 45,000 \]

Step 3 – Gross‑Margin

\[ \text{Gross‑Margin (\%)} = \frac{45,000}{120,000}\times100 = 37.5\% \]

5.2 Service Business Example (ConsultCo)

Item	Amount (£)
Total Receipts (fees)	85,000
Direct Staff Salaries	30,000
Sub‑contractor Fees	12,000
Materials Used	5,000

Because there is no inventory, COGS = 30,000 + 12,000 + 5,000 = 47,000.

Gross Profit = 85,000 – 47,000 = 38,000

Gross‑Margin = (38,000 ÷ 85,000) × 100 = 44.7 %

5.3 Club/Society Example (University Drama Society)

Item	Amount (£)
Total Receipts (ticket sales, memberships)	12,000
Direct Production Costs (set, costumes, royalties)	4,500

COGS (direct production costs) = 4,500.

Gross Profit = 12,000 – 4,500 = 7,500.

Gross‑Margin = (7,500 ÷ 12,000) × 100 = 62.5 %.

6. Interpretation of the Result (AO2)

• For every £1 of sales/receipts, the percentage shown remains to cover operating expenses, interest, tax and profit.
• Inter‑firm comparison: Compare the calculated gross‑margin with the industry average or with a competitor’s margin. A lower margin may indicate higher COGS or weaker pricing power.
• Interested parties:
  • Owners / Investors – evaluate the core profitability of the trading activity.
  • Managers – decide whether to focus on cost control, pricing strategy or product mix.
  • Creditors (banks) – assess the ability of the business to generate a surplus to meet debt obligations.
  • Suppliers – gauge the firm’s capacity to pay for future purchases.
• Possible actions to improve the margin:
  • Negotiate lower purchase prices or better payment terms with suppliers.
  • Reduce waste, improve stock‑turnover, or adopt just‑in‑time purchasing.
  • Introduce a modest price increase if the market will bear it.
  • Shift the product mix towards higher‑margin items.

7. Limitations of the Gross‑Margin Ratio (AO3)

• Ignores all operating expenses (rent, salaries, utilities, depreciation) – therefore it does not reflect overall profitability.
• Depends on the inventory valuation method used (FIFO, weighted‑average, LIFO). Different policies give different COGS figures, making cross‑industry comparison difficult.
• Based on historic cost data; it does not reflect current market prices or inflation.
• Not suitable for pure service businesses or clubs with negligible inventory; a contribution‑margin ratio is more appropriate in those cases.

8. Relationship to the Other Required Ratios

Ratio (Syllabus §6)	Formula	Key Interpretation Focus
Gross‑margin	(Sales – COGS) ÷ Sales × 100	Core trading efficiency; inter‑firm comparison; interested parties.
Profit‑margin (net‑profit margin)	Net Profit ÷ Sales × 100	Overall profitability after all expenses.
Return on Capital Employed (ROCE)	Operating Profit ÷ Capital Employed × 100	Efficiency of capital utilisation.
Current ratio	Current Assets ÷ Current Liabilities	Short‑term liquidity.
Liquid (quick) ratio	(Current Assets – Stock) ÷ Current Liabilities	Liquidity excluding inventory.
Inventory turnover	COGS ÷ Average Stock	How quickly stock is sold.
Receivables turnover	Credit Sales ÷ Average Debtors	Efficiency of credit collection.
Payables turnover	Credit Purchases ÷ Average Creditors	Speed of paying suppliers.
Contribution margin (for service/club)	(Total Receipts – Direct Costs) ÷ Total Receipts × 100	Profitability where inventory is irrelevant.

This table helps students see how gross‑margin fits into the full set of nine ratios required for the IGCSE analysis section.

9. Common Mistakes to Avoid

• Using net profit instead of gross profit in the numerator.
• Including overheads (rent, salaries, advertising) in COGS.
• Applying the gross‑margin formula to a pure service firm without adjusting COGS to direct service costs.
• Omitting purchase returns, freight‑in or other direct expenses when calculating COGS.
• Forgetting to use the correct “sales revenue” figure (e.g., using net sales after returns when the syllabus expects gross sales).

10. Practice Questions (AO2)

1. XYZ Co. reported sales of £250,000. Opening stock was £30,000, purchases £120,000 and closing stock £25,000. Calculate the gross‑margin percentage.
2. A retailer’s gross‑margin is 45 % and sales for the year were £80,000. What was the gross profit?
3. Compare two firms:
   • Firm A: Gross‑margin 38 %.
   • Firm B: Gross‑margin 42 %.
   Discuss two possible reasons why Firm B’s margin is higher.
4. ConsultCo (a service firm) earned total fees of £95,000. Direct staff salaries were £40,000, subcontractor fees £15,000 and materials £8,000. Calculate its gross‑margin.
5. The University Drama Society recorded total receipts of £14,000 and direct production costs of £5,200. Determine its gross‑margin and comment on its relevance for a club.

11. Answers to Practice Questions

1. COGS = 30,000 + 120,000 – 25,000 = 125,000

   Gross Profit = 250,000 – 125,000 = 125,000

   Gross‑Margin = (125,000 ÷ 250,000) × 100 = 50 %

2. Gross Profit = 45 % × £80,000 = £36,000.

3. Possible reasons for Firm B’s higher margin:

   • Better purchasing terms or lower unit costs, reducing COGS.
   • A product mix weighted towards higher‑margin items or a premium‑pricing strategy.

4. COGS (direct costs) = 40,000 + 15,000 + 8,000 = £63,000

   Gross Profit = 95,000 – 63,000 = £32,000

   Gross‑Margin = (32,000 ÷ 95,000) × 100 ≈ 33.7 %.

5. COGS = £5,200

   Gross Profit = 14,000 – 5,200 = £8,800

   Gross‑Margin = (8,800 ÷ 14,000) × 100 ≈ 62.9 %.

   For a club, this ratio is essentially a contribution margin, showing that a large proportion of receipts is left after covering the direct costs of productions.

12. Suggested Diagram