Gross margin, explained simply
Gross margin shows pricing power and production efficiency. A declining margin can indicate input cost inflation not passed on to customers, discounting or an adverse change in product mix, any of which affects future earnings.
Diligence analyzes margin by month, product and customer, and tests what is included in cost of goods sold and whether classification is consistent between years.
Gross margin by year
IllustrativeAlder Creek Manufacturing
Revenue grew every year while margin fell from 34.9% to 33.3%.
Calculation
Worked example
| $ millions | FY2023 | FY2024 | FY2025 |
|---|---|---|---|
| Revenue | 35.0 | 38.2 | 42.0 |
| Cost of goods sold | (22.8) | (25.2) | (28.0) |
| Gross profit | 12.2 | 13.0 | 14.0 |
| Gross margin | 34.9% | 34.0% | 33.3% |
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
Diligence finds that raw material costs rose and were not fully passed on to customers, and that discounts were given to win new accounts.
Why it matters in a deal
A falling margin can indicate weaker pricing power, rising costs or poor mix, all of which affect forecast earnings.
Red flags
- Margin changes caused by moving costs between categories
- Very different margins on similar products without explanation
- Margin spikes at period end