Gross Margin: Definition, Example, Formula, and How to Calculate

What Is Gross Margin?

Gross margin is the percentage of a company's revenue that's retained after direct expenses such as labor and materials have been subtracted. It's an important profitability measure that looks at a company's gross profit as compared to its revenue.

Gross profit is determined by subtracting the cost of goods sold from revenue. The higher the gross margin, the more revenue a company retains. It can then use the revenue to pay other costs or satisfy debt obligations.

Formula and Calculation of Gross Margin

$\begin{aligned}&\text{Gross Margin}=\bigg(\frac{\text{Net sales-COGS}}{\text{Net Sales}}\bigg)\times100\end{aligned}$​Gross Margin=(Net SalesNet sales-COGS​)×100​

Net Sales is the equivalent to revenue or the total amount of money generated from sales for the period. It can also be referred to as net sales because it can include discounts and deductions from returned merchandise. Revenue is typically called the top line because it appears at the top of the income statement. Costs are subtracted from revenue to calculate net income or the bottom line.

COGS is cost of goods sold. The direct costs associated with producing goods include both direct labor costs and any costs of materials used in producing or manufacturing a company’s products.

Imagine that a business collects $200,000 in sales revenue. Let's assume that the cost of goods consists of the $100,000 it spends on manufacturing supplies. The gross profit is therefore $100,000 after subtracting its COGS from sales. The gross margin is 50% or ($200,000 - $100,000) ÷ $200,000.

What Gross Margin Can Tell You

A company's gross margin is the percentage of revenue after COGS. It's calculated by dividing a company's gross profit by its sales. Gross profit is a company's revenue less the cost of goods sold. A company's gross margin is 35% if it retains $0.35 from each dollar of revenue generated.

COGS has already been taken into account so those remaining funds can consequently be channeled toward paying debts, general and administrative expenses, interest fees, and dividend distributions to shareholders.

Companies use gross margin to measure how their production costs relate to their revenues. A company might strive to slash labor costs or source cheaper suppliers of materials if its gross margin is falling or it may decide to increase prices as a revenue-increasing measure.

Gross profit margins can also be used to measure company efficiency or compare two companies with different market capitalizations.

The Difference Between Gross Margin and Net Margin

Gross margin focuses solely on the relationship between revenue and COGS but net margin or net profit margin is a little different. A company's net margin takes all a business's expenses into account. It's the percentage of net income earned from revenues received.

Businesses subtract their COGS as well as ancillary expenses when calculating net margin and related margins. Some of these expenses include product distribution, sales representative wages, miscellaneous operating expenses, and taxes.

Gross margin helps a company assess the profitability of its manufacturing activities. Net profit margin helps the company assess its overall profitability. Companies and investors can determine whether the operating costs and overhead are in check and whether enough profit is generated from sales.

The Difference Between Gross Margin and Gross Profit

Gross margin and gross profit are among the metrics that companies can use to measure their profitability. Both of these figures can be found on corporate financial statements and specifically on a company's income statement. They're commonly used interchangeably but these two figures are different.

Gross margin is a profitability measure that's expressed as a percentage. Gross profit is expressed as a dollar figure. Gross profit can be calculated by subtracting the cost of goods sold from a company's revenue. It sheds light on how much money a company earns after factoring in production and sales costs.

The Bottom Line

Different metrics can be used to measure a company's profitability. The gross margin is just one of these figures. Gross margin may also be called gross profit margin. It looks at a company's gross profit compared to its revenue or sales and is expressed as a percentage.

This figure can help companies understand whether there are any inefficiencies and if cuts are required to address them and increase profits. The gross margin is also a way for investors to determine whether a company is a good investment.