It is not uncommon in these days of high inflation to read in Annual Reports that "although sales have increased by 24 per cent in the year profits have fallen due to increases in production costs causing margins to erode". Margins indicate the earnings a company makes on its sales - its mark up on the cost of the items it manufactures/buys to sell. The higher the mark up the greater the profit per item sold and vice versa.Margins are so important that they determine the success or failure of a business. And the mark up or margin made by the seller is based usually on what he believes the market can bear or that which he thinks will fuel sales. Usually low volume businesses are high margin businesses as goods often have to be held for some time. Others such as supermarkets or for that matter brokers work at very low margins because volumes are very high.
Margins help to determine the cost structures of businesses i.e. are they high cost or low cost and whether the business is a high volume low marginbusiness or otherwise. This is important as it will indicate how dependant the company is on margins. If the company operates with low margins a small increase in costs can result in large losses.
The performance between companies within an industry or a group can also be compared with the help of margins. Let us assume that the gross margin earned by Hindustan York is 20 per cent whereas the industry average is 18 per cent. It can be argued in this instance that Hindustan York is more efficient and that its products command a greater premium. Efficient and strong managements will work to improve or keep margins constant. Margins help bankers to determine whether increases in costs (possible on account of inflation or governmental levies) have been passed onto customers in part or full. Should there be a demand for the product, companies will pass on the entire cost increase to customers. On the other hand, if the demand is not very much, the company would often bear a part of the cost increases because ifit does not, the customer would not purchase the product. A good example of falling margins is the TV industry. As competition is intense and the buyer has a choice of several makes, manufacturers have been bearing a portion of cost increases and in some instances dropped their prices in order to be competitive.
Product mix has an effect on margins. A company may be selling several products - each of them priced differently. Some may be high margin products and others low margin ones. If more high margin products are sold, the margin earned by the company would be high. Then should there be a change and more low margin products begin to be sold, the average margin earned on sales will reduce. It must be remembered that low margin businesses are not bad. Some of the most successful businesses in the world are low margin businesses that operate with very high turnovers and produce an impressive return of capital employed.
Gross margin
The gross margin is the amount earned expressed as a percentageof cost of sales. It is the excess earned to meet the expenses of the company. It is calculated by dividing the difference between sales and the cost of goods sold by sales and expressing it as a percentage of sales.
Sales - cost of goods sold X 100 sales A fall in gross margin could be due to several reasons such as:
Due to increased competition, the company has reduced margins to boost sales The company has taken a conscious decision to reduce its margins to improve sales. The margin has reduced because there has been a deterioration in the product mix. The company has been unable to pass on cost increases to customers.The banker would therefore not come to a conclusion on just seeing an improvement or a deterioration in the gross margin. He would go beyond the figures and seek the reasons for the change. An increase in the margin may be due simply to an increase in price whereas a fall could be due either as a consequence of a conscious decision to increase sales or aninability of the company to pass inflationary ost increases onto customers.
Operating margin
The profitability of a company before the cost of tax, miscellaneous income and interest costs is indicated by the operating margin. The operating margin can be arrived at by deducting, selling, general and administrative expenses from the gross profit and expressing it as a percentage of sales.Gross profit - selling, general & admin expenses x 100 sales A reason for an improvement in the operating margin could be that operating expenses have not risen as much as the increase in sales. This may not be the only reason.
In another situation the gross margin could have decreased (although sales may have gone up) and costs increased resulting in a fall in the operating margin. Normally this margin should improve since costs do not usually rise at the same rate as sales. In a recession or at a time of high inflation the reverse will be true. Costs may increase at a faster rate than sales and gross marginsmay also fall. Bankers always examine this ratio as it gives the likely reasons for an improvement or a deterioration in profitability and he must ascertain the actual causes.
Breakeven margin
Every organisation has certain expenses (selling, administration and other miscellaneous expenses) that it has to bear even if there are no sales. The BEM indicates the number of units that a company would have to sell to meet these expenses. When a company states that its breakeven is at half of its capacity it means the company would be in a no-profit-no-loss position if it produces and sells half its capacity. Any unit sold above this would yield a profit and vice versa. The ratio is had by dividing expenses including financing costs by the gross income per unit. Non recurring or unusal profits must be excluded from the calculation.
Expenses plus financing costs Gross income/Number of units soldSome bankers prefer to calculate this by deducting from the gross profit selling costs to arrive at the grossprofit per unit. This is because selling costs are connected with sales and no selling expenses would be incurred if no sales are incurred. This is arguably a purer measure. In my opionion this is an important measure as it indicates exactly how many units need to be sold by a company before it can begin to be profitable. This is an important management ratio too in decision making when alternatives are being considered.
Net profit margin
This shows the rate of earnings of a company after tax on sales. It indicates the rate on sales available for appropriation after all expenses and commitments are met. To facilitate comparison and get a true rate non recurring income and expense should be excluded in the calculation.Net income excliuding non recurring items after tax
Sales Summary
Margins help therefore in characterizing cost structures in businesses and comparing performance. It must always be remembered however that low margins are not always bad nor are high margins always good. Acompany may opt for volumes and to achieve this work on very low margins. Conversely a company earning high margins may have falling demand for its products. Investors must always check the reasons for variations and the measures mentioned in this article will help to indicate possible reasons.
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
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