What is ‘Gross Margin’
Gross margin is a company’s total sales revenue minus its cost of goods sold (COGS), divided by total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services it sells. The higher the percentage, the more the company retains on each dollar of sales, to service its other costs and debt obligations.
BREAKING DOWN ‘Gross Margin’
The gross margin number represents the portion of each dollar of revenue that the company retains as gross profit. For example, if a company’s gross margin for the most recent quarter is 35%, that means it retains $0.35 from each dollar of revenue generated. It spends the remainder on COGS. As COGS have already been taken into account, the remaining funds can be put toward paying off debts, general and administrative expenses, interest expenses and distributions to shareholders.
How to Calculate Gross Margin
To illustrate how to calculate gross margin, imagine a business collects $200,000 in sales revenue. It spends $20,000 on manufacturing supplies and $80,000 on labor costs. After subtracting its COGS, it has $100,000 in gross profits. Dividing gross profits by revenue equals 0.5, and when multiplied by 100, that becomes 50%.
Importance of Gross Margin
Companies use gross margin to measure how their production costs relate to their revenues. For example, if a company’s gross margin is falling, it may look for processes that allow it to cut labor costs or for suppliers who offer lower costs on materials. Alternatively, it may decide to increase prices to boost revenue.
Businesses may also use gross margins to forecast how much money they have left over from sales to cover other operating expenses. For example, if a company has a 50% gross margin, it knows that it only has $0.50 of each revenue dollar collected to devote to operating expenses. Gross profit margins can also be used to measure company efficiency or to compare two companies of different sizes to each other.
Difference Between Gross Margin and Net Margin
While gross margin only looks at the relationship between revenue and COGS, net profit margin takes all of a business’s expenses into account. When calculating net profit margins, businesses subtract their COGS as well as ancillary expenses, such as product distribution, wages for sales reps, miscellaneous operating expenses and tax. Gross margin, also called gross profit margin, helps a company assess the profitability of its manufacturing activities, while net profit margin helps the company assess its overall profitability.