Uncover the secrets behind gross, net, and processing margins in just one comprehensive guide.
To successfully run a profitable business, there are two things that every company wants to achieve – minimising the raw material cost and maximising profits. This is true for every business you see, be it a high-end brand in a luxurious mall or a local sandwich shop near your office.
At least once in your life, you might have thought that the food you ate outside cost much more than it would have if you had made it home. This is because businesses aim to make a profit but face challenges. However, certain businesses, like those dependent on commodities such as crude oil, steel, aluminium, or semiconductors, don’t have the flexibility to simply remove elements from their products. They have to bear the cost of high raw materials.
The final product’s price may also increase when raw material costs rise. However, many companies cannot suddenly pass on the cost to their customers. As a result, they have to endure the increased costs by reducing their profit margins. This brings us to the topic of discussion today – understanding Gross Processing Margin, Gross Profit Margin, and Net Profit Margin and how we can analyse businesses using these margins.
What is Margin?
Margin refers to the difference between the revenue generated from selling a product and the costs associated with producing that product. It is a crucial metric used to evaluate the profitability of a company’s operations.
When two companies are engaged in the same industry, comparing their margins can help determine which is more profitable. Higher margins generally indicate that a company is more efficient at controlling costs and generating profits from business activities.
Today we will look at three types of margins.
Gross Processing Margin
Gross processing margin and gross profit margin are often seen as the same. While these metrics are related, they are distinct from one another.
The gross processing margin is used in industries that process raw materials into finished products. It measures the difference between the cost incurred by the company to purchase raw materials and the revenue generated from selling the finished products.
The formula for calculating Gross Processing Margin is as follows:
Gross Processing Margin = Revenue from Finished Products – Cost of Raw Materials
For example, for a furniture manufacturing company, if the selling price of a dining table is Rs 10,000 and the cost of raw materials used to produce that table is Rs 5,000, the Gross Processing Margin would be Rs 5,000.
Gross Profit Margin
Now, while manufacturing goods, the companies incur direct costs like purchasing raw materials, labour and manufacturing expenses. This is called the cost of goods sold (COGS). Later the company sells the product for profits. But how much profit did the company generate while selling the product?
That’s where the gross profit margin is calculated. It tells you how much profit a business makes after paying for the direct cost of doing business. In a real business scenario, we would consider everything between sales and earnings before interest and tax (EBIT) while calculating the gross processing margin.
The formula for calculating Gross Profit Margin is:
Gross Profit Margin = (Gross Profit / Revenue) * 100
So, in the above example, assuming that the company made just one dining table and generated a revenue of Rs 10,000, while the COGS was Rs 5,000, the gross profit made by the business was Rs 5,000.
If we put that into the formula, we get the gross profit margin of the furniture business as 50%.
A higher gross margin indicates that a company effectively controls its production costs related to its revenue, which is a positive sign.
Secondly, when the company has strong pricing power in the market, the gross profit margins will be stable even when the prices of raw materials increase. This is because such companies can efficiently pass on the price hike to the end customer, and the customer accepts because they may have a strong brand image or produce exceptional products. In contrast, a company with no pricing power will have fluctuations in gross profit margin.
Net Profit Margin
The net profit margin goes a step further than the Gross Margin. It considers all expenses associated with running a business, including operating expenses, interest, taxes, and other non-operating items. So, here we deduct interest and tax from EBIT and calculate the profit after tax (PAT) or net profit the company has made in the duration.
Now, the net profit margin is the percentage of revenue that remains as profit after all expenses have been deducted.
If the furniture business had to pay Rs 1,000 in taxes and interest, we would deduct Rs 1,000 from the gross profits and get Rs 4,000 as the net profit.
But how much is the net profit margin of the business?
The formula for calculating Net Profit Margin is Net Profit Margin = (Net Profit/Revenue) * 100
So, the Net Profit Margin for the furniture manufacturing company, after considering taxes, is 40%.
A higher net margin indicates that the company efficiently manages its direct production costs (as reflected in the Gross Margin), operating expenses and taxes.
Analysing Margins of a Company
When investors analyse a company, one essential aspect they often consider is the trend of its gross profit margins over a longer time frame. Here, there are several trends that we often see, like the margins are stable or we see sudden spikes of volatility. Sometimes the margins are gradually increasing or decreasing. Why does such a trend take place, and what does it mean?
- Suppose a company’s margins are stable over a longer time frame (5 to 10 years). In that case, these businesses may have a contract with the end user stating that whatever price fluctuations happen in the raw material, the cost will be passed on to them. The second reason may be that they manufacture a unique or innovative product and have pricing power. Here, the consumer is okay with paying extra to get their hands on their products.
So, while analysing a business, you should look at a company’s margins over five to ten years. Moreover, you can also check the track record of the quarter-on-quarter and year-on-year margins. These numbers will tell you a lot about the company’s competitive advantages.
- Now, having stable margins is not always possible because the prices of raw materials keep fluctuating. Similarly, if geopolitical problems occur, demand increases, and hence we see a steep rise or fall in margins. This happens especially for businesses that depend on commodities for their operations, like oil and gas companies which depend on crude price fluctuations or companies which need iron ore, steel, etc., for their operations. They might also face fluctuations in their margins because of fluctuating prices of raw materials.
For example, in 2016, due to environmental concerns, China closed approximately 3,00,000 tonnes of its graphite electrode manufacturing capacity. This resulted in a scarcity of graphite electrodes. Consequently, the demand for graphite electrodes surged, benefiting manufacturers like HEG Ltd, a prominent graphite electrode producer and exporter in India. From 2016-17 to 2018-19, HEG Ltd experienced a remarkable rise in demand, witnessing a significant increase in its margins from 15% in 2016 and 9% in 2017 to an impressive 63% to 71% in 2018-19.
But, when companies worldwide expanded their capacities, the margins of HEG Ltd, fell again. Hence, while analysing a company, investors must have an idea of the track record of the company’s margins.
- Let’s now look at companies with margin expansion and deduction. The margins might expand when companies change their product mix or add value-adding products to their portfolio. The second reason is operating leverage. In simple words, a company has high operating leverage when it has more fixed costs (like rent and salaries) than variable costs (like raw materials).
When the company makes more sales, it doesn’t need to spend much extra on variable costs, but its fixed costs stay the same. So, the additional revenue from sales directly adds to the profit, making the profit margin bigger.
In contrast, a company with low operating leverage has more variable costs. When it makes more sales, it must spend more on raw materials than other variable expenses. This means the profit margin does not increase as quickly because the additional sales also come with higher variable costs.
So, as investors, you must look at the company’s product mix and understand if the company has an operating leverage advantage.
To conclude, understanding margins can help you understand a lot about the business you are analysing. So, while you invest, look at the margin trend over five to ten years and thoroughly understand the business and its profitability prospects before investing.
*The companies mentioned are for information purposes only. This is not an investment advice.
Note: This article was originally written by Teji Mandi for ET Markets.