Gross Margin

What Is Gross Margin?

Gross margin is net sales less the cost of goods sold (COGS). In other words, it's the amount of money a company retains after incurring the direct costs associated with producing the goods it sells and the services it provides. The higher the gross margin, the more capital a company retains, which it can then use to pay other costs or satisfy debt obligations. The net sales figure is gross revenue, less the returns, allowances, and discounts.

The Formula for Gross Margin Is

Gross Margin = Net Sales − COGS where: Net Sales = Equivalent to revenue, or the total amount of money generated from sales for the period. It can also be called net sales because it can include discounts and deductions from returned merchandise. Revenue is typically called the top line because it sits on top of the income statement. Costs are subtracted from revenue to calculate net income or the bottom line. COGS = Cost of goods sold. The direct costs associated with producing goods. Includes both direct labor costs, and any costs of materials used in producing or manufacturing a company’s products. \begin{aligned} &\text{Gross Margin} = \text{Net Sales} - \text{COGS} \\ &\textbf{where:} \\ &\text{Net Sales} = \text{Equivalent to revenue, or the total amount} \\ &\text{of money generated from sales for the period. It can also} \\ &\text{be called net sales because it can include discounts} \\ &\text{and deductions from returned merchandise.} \\ &\text{Revenue is typically called the top line because it sits} \\ &\text{on top of the income statement. Costs are subtracted} \\ &\text{from revenue to calculate net income or the bottom line.} \\ &\text{COGS} = \text{Cost of goods sold. The direct costs} \\ &\text{associated with producing goods. Includes both direct} \\ &\text{labor costs, and any costs of materials used in producing} \\ &\text{or manufacturing a company's products.} \\ \end{aligned} Gross Margin=Net Sales−COGSwhere:Net Sales=Equivalent to revenue, or the total amountof money generated from sales for the period. It can alsobe called net sales because it can include discountsand deductions from returned merchandise.Revenue is typically called the top line because it sitson top of the income statement. Costs are subtractedfrom revenue to calculate net income or the bottom line.COGS=Cost of goods sold. The direct costsassociated with producing goods. Includes both directlabor costs, and any costs of materials used in producingor manufacturing a company’s products.

To illustrate an example of a gross margin calculation, imagine that a business collects $200,000 in sales revenue. Let us assume that the cost of goods consists of the $100,0000 it spends on manufacturing supplies. Therefore, after subtracting its COGS from sales, the gross margin is $100,000. The gross profit margin is 50%, or ($200,000 - $100,000) / $200,000.

What Does the Gross Margin Tell You?

The gross margin (also referred to as gross profit) represents each dollar of revenue that the company retains after subtracting COGS.

However, gross margin may also be referred to as gross profit margin. For example, if a company's recent quarterly gross profit margin is 35%, that means it retains $0.35 from each dollar of revenue generated.

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

Companies use gross margin, gross profit, and gross profit margin to measure how their production costs relate to their revenues. For example, if a company's gross margin is falling, it may strive to slash labor costs or source cheaper suppliers of materials.

Alternatively, it may decide to increase prices, as a revenue-increasing measure. Gross profit margins can also be used to measure company efficiency or to compare two companies of different market capitalizations. 

The Difference Between Gross Margin and Net Margin

While gross margin focuses solely on the relationship between revenue and COGS, the net profit margin takes all of a business's expenses into account. When calculating net profit and related margins, businesses subtract their COGS, as well as ancillary expenses such as product distribution, sales rep wages, miscellaneous operating expenses, and taxes.

Gross margin helps a company assess the profitability of its manufacturing activities, while net profit margin helps the company assess its overall profitability.

How do we calculate gross margin?

Gross margin is revenue minus the cost of goods sold (COGS). Gross margin is sometimes used to refer to gross profit margin, which is revenue minus cost of goods sold (or gross profit) divided by revenue.

What is the difference between gross profit and gross margin?

Gross profit is revenue less the costs of goods sold. Gross profit and gross margin are sometimes used interchangeably. Meanwhile, gross margin and gross profit margin are also used interchangeably, Gross profit margin takes the gross profit (revenue less cost of goods sold) and divides it by revenue.

What is a good gross margin?

The gross margin varies by industry, however, service-based industries tend to have higher gross margins and gross profit margins as they don't have large amounts of COGS. On the other hand, the gross margin for manufacturing companies will be lower as they have larger COGS.