Gross margin is the percentage of a company's revenue after subtracting direct expenses such as labor and materials. Gross margin focuses exclusively on the relationship between revenue and cost of goods sold (COGS). The higher the gross margin, the more capital a company retains. And this extra capital can be used to pay other expenses or satisfy debts.
Highlights & Key Takeaways
- Gross margin is the difference between the revenue generated from sales and the cost of goods sold (COGS)
- Gross margin is one of the metrics used to determine a company’s profitability
- Gross margin is calculated as follows: Gross margin = (Revenue - Cost of Goods Sold) / Revenue x 100%
- Gross margins can vary across industries but generally, a gross margin of 10% or higher is considered good
What Is Gross Margin?
Gross margin is a measure of profitability that looks at a company's gross profit compared to its revenue or sales and is expressed as a percentage. The higher a company’s gross margin, the more capital it can keep. This capital can be used to pay other costs or satisfy debt obligations. Gross margin helps businesses understand how effectively they can generate revenue from their products or services.
To calculate gross margin, you can use the following formula:
Gross margin = (Revenue - Cost of Goods Sold) / Revenue x 100%
How Can Gross Margin Be Used?
Gross margin is used across a wide variety of industries. Think of the popular television show Shark Tank. The investors ask questions about sales, manufacturing, distribution, and more with each prospective business entrepreneur. But things tend to get hairy when they start asking about profitability, and rightfully so. The investors, aka sharks, need to understand how much money they can make if they support the entrepreneur’s investment request. So, they want to understand revenue and costs. Once they have the info, they make the following calculations:
- Revenue – COGS = Gross Profit
- Gross Profit / Revenue = Gross Profit Margin
So, understanding the gross margin can help the sharks determine the following:
- Potential profitability
- How prices are set
- How the products are services are performing
- How the competition compares
- If operations are efficient
Why Is Gross Margin Important?
While gross margin is used in the ways mentioned above, it might not yet be clear how important this metric is in evaluating the pricing of a company’s products and services. Gross margin is important for the following reasons:
- To demonstrate profitability - As gross margin shows how much money is left over after deducting the COGS from the revenue generated from sales, a high gross margin can indicate the company is making more money from its products and services.
- To determine pricing strategies - A low gross margin can indicate that a company is not making enough on each product or service they sell. But, by calculating the cost of producing or acquiring a product and adding a desired gross margin, a company can arrive at the right selling price, which is competitive yet profitable.
- To determine efficiency - A gross margin rate that is on the decline could be a red flag indicating that production or acquisition costs are increasing or that the company is not generating enough revenue from its products or services. Increasing gross margin suggests that a company is generating more revenue from its products or services relative to the cost of goods sold (COGS).
- To get insight into financial performance - A consistent gross margin over time tells investors and stakeholders that the company is effectively managing costs and generating revenue.
How To Calculate Gross Margin
To calculate gross margin, follow these steps:
- Start by calculating the total revenue for the desired reporting period.
- Calculate the COGS by subtracting the inventory value at the end of the period from the inventory at the beginning, plus any purchases.
- After determining the total revenue and COGS, add these variables to calculate the gross margin.
Sounds confusing? Let’s try a more straightforward and mathematical approach. Consider a company that sells a pair of high-end tennis shoes for $200 each. The cost of producing those tennis shoes is $65 per pair. To calculate gross margin, use the following formula.
Revenue = $200
Cost of Goods Sold = $65
Gross Margin = ($200 - $65) / $200 x 100%
Gross Margin = $135 / $200 x 100%
Gross Margin = 0.675 x 100%
Therefore, the gross margin for these high-end tennis shoes that sell for $200 each with a production cost of $65 per pair is 67.5%.
What Is the Formula for Gross Margin?
The formula to calculate gross margin is:
Gross margin = (Revenue - Cost of Goods Sold) / Revenue x 100%
Example of a Gross Margin Calculation
Let’s calculate the gross margin for a landscaping company that generates $100,000 in revenue for the spring season. To do this, we need to understand the revenue and the cost of providing those services, including expenses such as direct labor, landscaping equipment, materials, etc. If those expenses totaled $70,000, the calculation would look as follows:
Gross Margin = ($100,000 - $70,000) / $100,000 x 100%
Gross Margin = $30,000 / $100,000 x 100%
Gross Margin = 0.3 x 100%
Gross Margin = 30%
This means that the gross margin made by the landscaper in the spring is 30%.
Limitations of Gross Margin
While gross margin is an important metric to determine profitability, you must remember that it is simply the calculation comparing how much you sell a product versus how much it costs to make or acquire it. As such, using gross margin alone has some limitations.
- Doesn’t include operating expenses - Calculating gross margin doesn’t consider operating expenses such as employee wages, the cost to rent office space or storage facilities, marketing expenses, utilities, etc. For this reason, a company with high operating expenses can have a high gross margin with low profits.
- Gross margins can’t be compared across industries - Gross margins can only be used as a comparison to like or very similar products or services. So, comparing the gross margins for a shoe manufacturer with a landscaping company would not make sense.
- Masks inefficiencies - As suggested earlier, a company with high operating expenses may have a high gross margin but low profits. As such, gross margin can hide potential inefficiencies such as a bad pricing strategy.
- Doesn’t reflect price changes - Prices must be adjusted for changing costs, new market demands, and more. The gross margin doesn’t reflect the price changes that a company might need to make.
Gross Margin vs. Net Margin
Gross margin and net margin are profitability ratios used to assess a company’s financial well-being. Both gross profit margin and net margin or net profit margin are expressed in percentage terms and measure profitability compared to revenue for a given period (such as a month, quarter, or fiscal year). Further, it’s important to clarify that while profit and net margin are terms often used interchangeably, they are not the same. Here is a quick summary of the difference between gross, net, and profit margins.
- Gross margin - This shows the difference between sales revenue and COGS generated.
- Net margin - This represents the percentage of profit earned from a company's total revenue after deducting all expenses, including operating expenses, taxes, interest payments, and other non-operating expenses.
- Profit margin - This represents the percentage of revenue that a company keeps as profit after accounting for all costs and expenses.
What Is Net Margin?
Let’s get into more detail about net margin. Net margin measures a company's ability to generate profit from every dollar of revenue it generates. It is a critical indicator of financial health and efficiency because it demonstrates how much profit the company is making after all of its expenses have been paid.
- A high net margin indicates that a company can generate significant profits from its sales
- A low net margin suggests that the company is either operating inefficiently or facing strong competition that is driving down its profitability
Therefore, net margin is a crucial metric for investors and analysts to evaluate a company's financial performance and to make investment decisions.
How Is Gross Margin Different from Net Margin?
Gross margin is the difference between a company's revenue and the cost of goods sold (COGS), expressed as a percentage of revenue. It measures a company's profit after accounting for the direct costs of producing or acquiring the goods it sells. In other words, gross margin represents the amount of money a company has remaining to cover its operating expenses and generate net income.
Net margin is also a percentage of revenue but represents a company's net income after all expenses, including operating expenses, interest expenses, and taxes, have been deducted. It provides a more holistic snapshot of a company's profitability because it considers all expenses, not just the costs of producing or acquiring goods.
Gross Margin vs. Gross Profit
Gross margin measures a company's financial efficiency, sometimes called the gross profit or gross margin percentage. It measures how much profit your business secures per dollar of sales. More specifically, gross margin equals your gross profit divided by your total sales revenue, multiplied by 100, resulting in a percentage value.
Frequently referred to as net income, gross profit measures a company’s dollar amount of profits after deducting its production costs. So, gross profit equals a business’s total sales revenue minus its production costs, commonly called COGS. Gross margin and gross profit are used to measure a business’s profit.
What Is Gross Profit?
Gross profit can be a useful metric to help you determine your company’s spending power and your variable costs.
- Working out gross profit tells you how much you earn after expenses over a period. This helps you know how much money to reinvest in your business. And in this case, especially when investing in your business, a dollar figure is more helpful than a percentage.
- Gross profit also shows how efficiently you use your resources, such as labor, raw materials, and supplies. If your gross profit is high, it may indicate that your variable costs are under control and that your business is efficiently producing or delivering its products or services. On the other hand, a low gross profit could indicate that your variable costs are too high, and you need to review your cost structure to identify areas where you can reduce costs and improve profitability.
Let’s understand gross margin and gross profit in a business example. Earlier, we calculated the gross margin for a landscaping company that generates $100,000 in revenue for the spring season. The calculation looked as follows:
Gross Margin = ($100,000 - $70,000) / $100,000 x 100%
Gross Margin = $30,000 / $100,000 x 100%
Gross Margin = 0.3 x 100%
Gross Margin = 30%
Let’s revisit our landscaping company mentioned earlier. Gross profit is calculated as follows:
Gross profit = sales revenue – cost of goods sold (COGS)
So, to get at the gross profit, we need to subtract the COGS ($40,000) from our revenue ($100,000).
Revenue = $100,000
Cost of goods sold (COGS) = $40,000
Gross profit = Revenue - COGS = $100,000 - $40,000 = $60,000
Therefore, the gross profit for our landscaping company is $60,000.
How Is Gross Margin Different from Gross Profit?
Gross margin and gross profit are important to help a business understand its profitability, but they represent different aspects of a business's financial performance.
- Gross profit is the total revenue a company generates minus the cost of goods sold (COGS), which includes all of the direct costs associated with producing or delivering a product or service. The gross profit is an absolute dollar amount representing the total profit generated by the company's core business operations.
- Gross margin is a percentage that represents the proportion of revenue that is left over after accounting for the cost of goods sold. To calculate gross margin, divide the gross profit by the revenue and multiply the result by 100 to get a percentage. Gross margin is a percentage because it allows you to compare the profitability of different businesses with different revenue levels.
Gross Margin vs. Operating Margin
Now, let’s look at operating margin and how that compares to gross margin. Whereas gross margin represents the percentage of revenue that remains after accounting for the cost of goods sold (COGS), operating margin measures the percentage of revenue that is left over after accounting for all operating expenses.
Think of gross margin as a measure of a company's production efficiency and pricing strategy. It shows how well a company manages its direct costs, such as labor and materials, and is calculated by dividing the gross profit by revenue. Conversely, operating margin measures a company's profitability after accounting for all operating expenses, including salaries, rent, marketing, and other overhead costs. It is calculated by dividing operating income by revenue.
Now let’s calculate the operating margin for our landscaping company. To do so, we need to determine our operating income and revenue. So, if we generated $500,000 in revenue and had $100,000 in operating income (after deducting all operating expenses), the operating margin would be:
Operating margin = (Operating income / Revenue) x 100
Operating margin = ($100,000 / $500,000) x 100
Operating margin = 20%
This means that your company generated a 20% profit from its core operations after accounting for all of its operating expenses.
How to Increase Gross Margin
With fluctuating costs, business owners in all industries should look to grow their gross profit margin. Doing so can provide a financial cushion that ensures overhead expenses can be covered and provides more financial freedom to explore ways to grow.
Here are some tried-and-true ways to increase gross margin in your company.
- Streamline your product offerings - remove less profitable offerings
- Negotiate better deals with your suppliers
- Develop an upsell strategy to increase your business with existing clients
- Improve your efficiency and productivity
What is a Good Gross Margin For a Business to Have?
As every business is unique, it can be hard to ascertain a good gross margin across industries. New businesses may have better percentages before needing to scale production and services. And, a low gross margin doesn’t necessarily create cause for alarm on its own (though it does likely means high sales volumes are necessary to maintain the business).
Comparing gross profit margins with competitors can help business leaders and analysts determine how much of their costs can be passed on to customers before they begin looking elsewhere. And several factors influence the profit margin of a business, including:
- Pricing strategy
- Cost of goods sold (COGS)
- Operating expenses
- Industry competition
- State of the economy
- Marketing and advertising
This said, many experts in the finance industry, including investors, analysts, and business owners would indicate that a profit margin of 10% or higher is considered good, but the higher, the better.
Final Word
To answer the question, what is gross margin, you should know that it is a key metric for evaluating the pricing, profitability, efficiency, and financial performance of a company's products and services. A 10% or better gross margin is often considered good and can help businesses understand how effectively they generate revenue from their products or services.
