What Is Gross Margin?
Gross margin is the percentage of a company’s revenue that it retains after direct expenses—such as labor and materials—have been subtracted. As an essential profitability measure, gross margin compares a company’s gross profit to its revenue.
Gross profit is determined by subtracting the cost of goods sold (COGS) from revenue. The higher the gross margin, the more revenue a company retains, which it can use to pay other costs or satisfy debt obligations.
Key Takeaways
- Gross margin measures a company’s gross profit relative to its revenues as a percentage.
- A higher gross margin means a company retains more capital.
- If a company’s gross margin drops, it may react by cutting labor costs or sourcing cheaper suppliers.
- While the gross margin focuses on revenue and COGS, the net profit margin takes all business expenses into account.
Formula and Calculation of Gross Margin
To calculate gross margin, use the following formula:
Gross Margin = (Net Sales - COGS) / Net Sales
Where:
- Net Sales = Revenue generated from sales, including any applicable discounts and deductions from returned merchandise. Revenue is typically referred to as the top line of the income statement.
- COGS (Cost of Goods Sold) = Direct costs associated with producing goods, including direct labor costs and material costs used in manufacturing.
Example Calculation
Imagine a business collects $200,000 in sales revenue. The cost of goods sold comprises $100,000 spent on manufacturing supplies. Therefore, the gross profit is $100,000, and the gross margin is 50%, calculated as follows:
Gross Margin = ($200,000 - $100,000) / $200,000 = 50%
What Gross Margin Can Tell You
A company’s gross margin is the percentage of revenue remaining after accounting for COGS. By dividing a company’s gross profit by its total sales, you ascertain its gross margin. For example, a company that retains $0.35 from each dollar of revenue generated indicates a gross margin of 35%.
Since COGS is already deducted, the remaining funds can cover debts, general administrative expenses, interest fees, and dividends to shareholders. Companies use gross margin to measure how production costs relate to revenues. A falling gross margin might prompt a company to cut labor costs, source cheaper materials, or raise prices to boost revenue and gross margins.
Note
Gross margin may also be referred to as the gross profit margin.
The Difference Between Gross Margin and Net Margin
Gross margin focuses on the relationship between revenue and COGS. Conversely, net margin (or net profit margin) considers all business expenses, determining the percentage of net income earned from revenues.
Net margins account for COGS and other expenses like product distribution, sales wages, operating expenses, and taxes, helping assess overall profitability and operating costs efficiency against gross profit margin which is limited to production profitability.
The Difference Between Gross Margin and Gross Profit
Gross margin and gross profit are both significant measures but are different metrics used to assess profitability. Gross margin is expressed as a percentage, measuring gross profit relative to revenue. Gross profit, expressed as a dollar figure, is calculated by subtracting COGS from revenue, indicating earnings post-production and sales costs.
How to Calculate Gross Margin
Calculating gross margin involves the following steps:
- Subtract COGS from the company’s total revenue to get the gross profit (a dollar figure).
- Divide the gross profit by the total revenue.
- Multiply the result by 100 to express it as a percentage.
What Is the Difference Between Gross Margin and Gross Profit?
While both metrics factor in revenue and COGS, they serve different purposes. Gross profit is revenue minus COGS, expressed as a dollar amount. Gross margin, on the other hand, compares gross profit to sales, expressed as a percentage.
What Is a Good Gross Margin?
Gross margin varies by industry. Service-based industries tend to have higher gross margins due to lower COGS, whereas manufacturing industries often have lower gross margins due to significant COGS.
The Bottom Line
While gross margin is one way to measure a company’s profitability, it’s crucial to understand its relation to overall efficiency. Gross margin indicates a company’s production profitability and potential inefficiencies that may need addressing. For investors, gross margin is a valuable metric in determining whether a company represents a solid investment.
Related Terms: Profit Margin, EBITDA, Operating Margin, Net Income.
