What is gross margin?
In business, gross margin is a highly useful indicator of financial success or failure. Basically, the higher the gross margin, the more cash a company earns from a sale, after accounting for cost.
By definition, gross margin is the amount of money left over after a company subtracts its cost of products or services sold from its net sales, also known as the “cost of goods sold (COGS)." Essentially, gross margin represents the gross profit a company makes after a sale, minus the cost it incurred in producing a product or service.
Gross margin can be a wide-ranging business benchmark. It can be effectively used in the following ways:
- After the sale of an individual product or service, for an entire product campaign, or to ascertain the gross profits from everything a company sells.
- In addition to gross profit, gross margin can also be used as a percentage of net sales, which in business lingo is commonly known as gross profit percentage or gross margin ratio.
- Gross margin can be used as an accounting comparison metric outside a company. For example, a company can measure its gross margin percentage or ratio against an industry competitor, as a gauge on how the company is faring financially against its competition.
Basically, businesses use gross margin to benchmark their production costs against their sales revenues. If gross margin is down, a business may elect to curb expenses in key areas like staffing, research or manufacturing, in an effort to improve the financial bottom line. On the other hand, a company may opt to boost prices for its goods and service in an effort to bolster its financial numbers.
The value in a good gross margin calculation is knowing that a company needs to take action to cut expenditures or raise prices, and by how much on an ongoing basis. That alone makes gross margin a valuable financial indicator for any business, big or small.
Gross Margin Example
For a good example of how gross margin works in the real world, let’s look at a fictional retailer called ABC Landscaping, which caters to businesses and homeowners looking to take good care of their properties.
ABC Landscaping had net sales of $2 million in 2018 against inventory and production costs of $1.5 million for the year. That leaves the company with a gross margin of $500,000, after those inventory and production costs were paid off.
In 2019, ABC Landscaping generated sales of $2.25 million, and curbed its business production costs to $1.25 million. That translates into a good year for the company financially, with a gross margin of $1 million for 2019.
In this scenario, ABC Landscaping is doing better financially because it figured out how to boost revenues while at the same time cutting costs.
This is an optimal outcome for a gross margin scenario.
If ABC Landscaping had revenues of $2 million again in 2019, but its production costs rose to $1.75 million, its profit would be cut by $250,000, signaling a down year in 2019 for the company. In that scenario, the company is growing, but it’s making less of a profit, based on its gross margin ratio.
How to Calculate Gross Margin
Since gross margin represents the gross profit of a company measured against its revenues (just like the case of ABC Landscaping), it’s really calculating the proportion of business revenue that winds up becoming the company’s gross profit. That’s what sales revenues minus COGS really means.
To calculate that gross margin, most companies use the following formula:
1. Subtract the cost of goods sold from total revenue.
2. Divide that figure by total revenue (gross margin = (total revenue minus cost of goods sold/total revenue.
Thus, the formula to calculate gross margin as a percentage is as follows:
Gross margin = (total revenue minus cost of goods sold)/total revenue times 100.
A company’s gross profit and sales figures are included in its business income statement. Or, gross profit may be ascertained by subtracting the cost of goods sold from its sales revenues.
Now, let’s break down what each term means in the above gross margin calculation
Revenue minus cost of goods sold = gross profit or gross margin. This represents the total costs of producing a product or service.
Direct costs = The direct or total cost, minus external company financial factors such as interest payments on financing, operating expenses, or tax obligations incurred by a company.
Gross Margin Versus Net Margin
Gross margin and net margin are not the same things, as the differences are significant:
Gross margin represents the difference between a company’s sales revenues and its costs of goods sold. That leaves money, known as the residual margin, to cover the costs of necessary expenses like administrative and sales and marketing costs.
Net margin is the amount of money remaining after those other expenses (i.e., the administrative and sales costs) are paid down. Consequently, the gross margin is always larger than the net margin, as it does not include the above expense in its calculation.
On an income statement, you’ll find the gross margin right below the COGS line. That’s higher up on an income statement than net margin, which is usually located at the bottom of the sheet, after the listing of expense line items.
What Gross Margin Lets You Know
Gross margin is essentially the percentage of each revenue dollar a company can keep in gross profit.
It tells company financial decision-makers how the firm is performing in terms of sales and production. By accounting for the cost of goods sold against total revenues, those company decision-makers now have a good grip on the firm’s total revenue.
For example, if a business winds up having a gross margin of 30%, it’s basically telling the company that 30% of its total revenues are its total profit.
Again, the higher the gross margin, the more efficient a company is performing financially. A lower gross margin means a company’s operational processes aren’t as lean as they could be, and that those processes are cutting into a company’s profit.
Using gross margin as a benchmark enables a company to make some useful and practical decisions. For example, gross margin can tell a business which products to keep selling which ones to stop selling. It can tell them whether to hike prices on a product or service or cut prices.
It can also tell a company which products or services need to be marketed more aggressively and what products or services should see their marketing and advertising budgets reduced – if not eliminated altogether.
The Takeaway on Gross Margins
Gross margins are an especially useful financial tool that helps companies figure out how they’re doing on two key fronts – sales revenues and the cost of doing business.
By figuring out how its cost of goods sold matches up against to revenues, a company has a much better idea of where it needs to improve or where it's succeeding on a regular basis. It also has a better idea of how to use that gross margin metric as a benchmark for improved profitability throughout the entire company.