This number represents what was spent in the direct production of goods for sale. For example, material used to produce clothing in a retail organization would fall in this category.
Salaries for home office employees would not.
If this number is increasing faster than revenue, even as a percentage of revenue, gross margins will fall. Analysts watch this very closely in a retail organization.
Merely cutting prices to increase the top line is not always a good thing.
For example, let’s say a company has 35% gross margins; in other words, for $1,000 of sales (100 units @ $10 each), they make $350 in gross profit. This also means the direct costs of the goods sold involved in making the product was $650. The $650 does not change if the top line changes, at least in the short run.
If we reduce our unit price from $10 to 8$ so that we now sell 150 units, we have total sales of $1,200 (150 @ $8 each). However, we still paid $6.50 to make each unit. As such, our COGS for those 150 units is $975 (150 @ $6.50). Our gross profit at this point is $225 ($1,200 – $975). As such, our gross profit margin is now a little over 18%. Also notice that our total profit is also less than it was @ $10 unit.
This can actually be a dual edged sword, as you sell more units at a lower price, but the at the same per unit cost, making your COGS increase more quickly than normal.
Whenever a company has to discount this heavily, two glaring concerns come to the forefront:
1) Why is no one buying the products at the higher prices?
2) Has the company permanently reset their pricing structure? In other words, would anyone ever again pay the original higher price?
Think about any of a million fads in your lifetime; it may be the pet rock, or Beanie Babies, or Pokemon trading cards. As soon as the bottom drops out, it can be impossible to recover.