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Statement analysis
Three of the four causes are economic. The fourth is an accounting reclassification that moves the line several points with no change to the business at all. Here is how to tell which one you are looking at.
9 min read· Corva Research
The short version
Gross margin is revenue minus cost of revenue, divided by revenue. It is the first profitability line on the income statement and the one most sensitive to how a company chooses to classify its own costs.
That second half is the part almost nobody writes about. Search for why gross margin falls and you will get advice on fixing it: renegotiate with suppliers, review your pricing, control your overhead. All of it is written for someone running the business. None of it is written for someone reading a filing and trying to work out what happened.
So here are the four causes, and a one-minute test that tells you which one you have. Three are real. One is not.
On its own, almost nothing. A single year of gross margin is a ratio between two numbers the company defines itself, and there is no rule requiring any particular cost to sit in cost of revenue.
US GAAP does not prescribe the contents of the line. Companies decide whether to put shipping, customer support salaries, amortisation of acquired technology, or depreciation on production equipment above or below the gross profit line. Two companies selling the same product can report gross margins ten points apart and both be right.
Which means a margin that fell tells you a ratio changed. It does not yet tell you the business changed. Those are different claims, and separating them is the whole job.
The obvious one, and the one most articles stop at. Materials, freight, contract manufacturing, energy, or production labour cost more per unit than they did last year, and pricing did not keep up.
What it looks like in the filing:
This is the cause management most readily discusses, because it is external and reversible. Read the language carefully anyway. "Elevated freight costs" that persist for nine straight quarters are not elevated. They are the new base.
The company sold the same things for less. Discounting, promotional pricing, a large customer renegotiating on renewal, or list prices holding while realised prices slip through rebates and credits.
This one is harder to see, because revenue can still grow while realised price falls. Volume covers it.
What separates it from cause 1:
Price-driven compression is the more serious of the two. Input costs can retrace. A price the customer has learned to pay is much harder to take back.
Nothing got more expensive and nothing got cheaper. The company simply sold more of the low-margin thing and less of the high-margin thing, and the blended average fell.
This is the most commonly misread of the four, because it can accompany a genuinely good year. A hardware business that wins a very large low-margin platform deal will show revenue up and gross margin down, and both facts are true and neither is a problem.
The tell is in segment reporting. If the company discloses margin by segment or by product and service, compute each one separately. If every individual margin held and the blended margin fell, the cause is mix, and there is no cost or pricing problem to find.
Most explainers list mix as one item in a bullet list and move on. It deserves the segment note, because it is the one cause that is fully checkable from disclosure.
A company can change where an expense sits on the income statement. The expense is the same, the cash is the same, the business is the same. Gross margin moves.
This is a reclassification, and it is legal, disclosed, and routine. The typical candidates are amortisation of acquired technology, customer support salaries, depreciation on production assets, and shipping and handling. Any of them can sit above or below the gross profit line depending on how management reads its own cost structure.
When a company moves one of these into cost of revenue, gross margin falls immediately and permanently, and operating income does not move by a single dollar, because the expense was already in the total either way.
Everything below the gross profit line absorbs the change exactly. That is what makes the fourth cause identifiable in one step.
Companies restate the prior years to match, so a chart of five years of gross margin drawn from the latest filing will look smooth and show no break at all. The discontinuity only appears if you compare the old filing against the new one, or read the note.
In the fourth quarter of 2021, Ribbon Communications (RBBN) moved amortisation of certain acquired intangible assets out of operating expenses and into cost of revenue. The 10-K describes it plainly:
"In the fourth quarter of 2021, the Company reclassified amounts recorded for amortization of certain acquired intangible assets in prior presentations from Total operating expenses under the caption 'Amortization of acquired intangible assets' to Cost of revenue under the caption 'Amortization of acquired technology' in the consolidated statements of operations."
Here is what that did to two prior years, using the company's own restatement table.
| $000s | 2020 filed | 2020 revised | 2019 filed | 2019 revised |
|---|---|---|---|---|
| Total revenue | 843,795 | 843,795 | 563,111 | 563,111 |
| Total cost of revenue | 350,688 | 392,978 | 208,454 | 246,027 |
| Gross profit | 493,107 | 450,817 | 354,657 | 317,084 |
| Gross margin | 58.4% | 53.4% | 63.0% | 56.3% |
| Total operating expenses | 491,438 | 449,148 | 544,117 | 506,544 |
| Operating income | 1,669 | 1,669 | (189,460) | (189,460) |
Gross margin fell 5.0 points for 2020 and 6.7 points for 2019, and operating income is identical in both columns. Source: Ribbon Communications FY2021 Form 10-K, Notes to Consolidated Financial Statements, Reclassifications. Filed 11 March 2022. Margins computed from the figures shown.
The amounts moved were $42.3m in 2020 and $37.6m in 2019. Revenue did not change. Operating income did not change. Cash did not change. The 10-K says so directly: "These reclassifications did not impact operating income (loss), net income (loss) or earnings (loss) per share for any historical periods." It adds that the balance sheet and the cash flow statement were untouched as well.
An analyst who pulled Ribbon's five-year gross margin from a data provider in 2022 and compared it against a note written in 2020 would have found six points of apparent deterioration that never happened.
The four causes fall out of two questions, asked in this order.
First: did operating income move by the same amount as gross profit? If gross profit fell by $42m and operating income fell by $42m, the money genuinely left. If gross profit fell by $42m and operating income did not move at all, an expense changed address. That single comparison isolates cause 4 from the other three, and it takes about a minute.
Second, if the money really did leave: did each segment margin hold? Compute margin for every segment or revenue type the company discloses. If they all held and the blended figure fell, the cause is mix. If individual margins fell, you are in cause 1 or 2, and the split between them is whether unit cost rose or realised price fell.
| Cause | Op income moves? | Segment margins fall? | Confirm in |
|---|---|---|---|
| 1. Input costs | Yes | Yes | MD&A costs; inventory |
| 2. Realised price | Yes | Yes | Revenue split; DSO |
| 3. Mix | Yes | No | Segment note |
| 4. Reclassification | No | n/a | Accounting policy note |
Two things to note about that table. The fourth row is the only one where the answer to the first column is no, which is why the test works. And the third row is the only one where a falling headline margin is compatible with every underlying margin being fine.
The two-question pass separates the four causes. It does not tell you whether the company is a good investment, and it has real limits worth stating.
Not any cost, but the boundary is far wider than most readers assume. US GAAP does not prescribe the contents of the line, so shipping, customer support, amortisation of acquired technology and production depreciation are all genuinely discretionary in placement. Companies must apply their policy consistently and disclose changes, which is exactly why the accounting policy note is where this gets caught.
Yes. A company that changes presentation restates the comparative periods and describes the change, usually in the first accounting note. It will also state whether operating income, net income and earnings per share were affected. In Ribbon's case the filing says plainly that they were not.
Because providers pull the restated figures from the most recent filing, which applies the new presentation to every prior year. The break disappears. The only way to see it is to compare two filings, or to read the note.
No. Under cause 3 it can accompany a genuinely good year, when a company wins large lower-margin volume that adds gross profit in absolute dollars while diluting the percentage. Gross profit in dollars and gross margin in percent can move in opposite directions, and the dollars are what fund the business.
Realised price. Input costs can retrace and mix can shift back, but a price the customer has learned to pay is difficult to raise again. A reclassification, by definition, is not serious at all in economic terms.
Corva reads the filings and reconciles the margin line against operating income and the segment note, then flags the accounting policy changes that moved a ratio without moving the business. Figures are computed from the filed statements and cross-checked against SEC EDGAR. Where a number cannot be found, it says so rather than inventing one.
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Corva is a research tool, not a broker or investment adviser, and nothing here is a recommendation to buy, sell or hold any security. Ribbon Communications is used here as a documented example of a disclosed accounting reclassification and for no other reason. All figures are taken from the company's Form 10-K for the year ended 31 December 2021, filed 11 March 2022; margins are computed from those figures. Verify anything you intend to act on against the primary filing. See terms and disclaimer.