What Is Gross Margin?
The gross margin is the difference between a company’s net sales revenue and its cost of goods sold (COGS). In other words, it is the amount of sales money a company keeps after paying for the direct costs of creating the goods and services it sells. The bigger the gross margin, the more money a company keeps from each dollar of sales, which it can utilize to cover other expenses or pay off debt. Returns, allowances, and discounts are subtracted from gross income to arrive at the net sales amount.
The Formula for Gross Margin Is
Gross Margin=Net Sales−COGSwhere: 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 cost associated with producing goods. Includes both direct labor costs and any costs of materials used in producing or manufacturing a company’s products.
How to Calculate Gross Margin?
Consider a business that receives $200,000 in sales revenue as an example of a gross margin calculation. Assume that the cost of goods is made up of the $20,000 spent on manufacturing inputs plus the $80,000 spent on labor. As a result, after deducting COGS, the corporation has a gross margin of $100,000.
What Does the Gross Margin Tell You?
The gross margin is the percentage of revenue that is retained as gross profit by the company. For example, if a company’s current quarterly gross margin is 35%, it implies it keeps $0.35 out of every $1 of revenue. Because COGS have already been deducted, the remaining funds can be used to pay debts, general and administrative expenses, interest costs, and dividend payouts to shareholders.
Gross margin is a metric used by businesses to determine how their production expenses compare to their revenue. If a company’s gross margin is shrinking, for example, it may try to cut labor expenses or find cheaper material suppliers. Alternatively, as a revenue-generating measure, it may opt to raise prices. Gross profit margins can also be used to compare two companies with differing market capitalizations or to gauge corporate efficiency.
The Difference Between Gross Margin and Net Margin
While the gross margin is exclusively concerned with the link between revenue and the cost of goods sold, the net profit margin considers all of a company’s expenses. Businesses remove COGS from net profit margins, as well as ancillary charges including product distribution, sales rep salary, miscellaneous running expenses, and taxes.
Gross margin, often known as “gross profit margin,” is used to measure the profitability of a company’s manufacturing activities, whereas net profit margin is used to measure the company’s overall profitability.
Definition of Gross Profit Margin
In financial statement analysis, the gross profit margin is a typical ratio. Internally, as part of their pricing system, or externally, to compare their company to similar companies, management can utilize gross profit margin. Investors can use gross profit margin to compare two companies in the same way.
The gross profit margin is a metric that shows how much a company keeps after subtracting the cost of goods sold from each dollar of sales. For example, if a corporation has a 75 percent gross profit margin, it will keep 75 cents for every $1 in sales.
Revenues minus cost of goods sold, then divided by revenues, is the formula for gross profit margin. For instance, suppose a company’s revenue is $100 and its cost of products sold is $25. The result is $75 when $100 is subtracted from $25. Finally, 75 percent = $75 divided by $100.
Location of Variables
The top line on a company’s income statement is usually revenues. The cost of products sold appears on the income statement as well, usually next to revenues. Internally, a corporation can compute revenues by multiplying the number of product sales by the product’s selling price. For example, suppose a corporation sells $5 widgets and sells 20 over the course of a month. The revenue is calculated as 20 units multiplied by $5, which is $100.
Investors use gross profit margin as a comparison tool. Investors can compare the gross profit margins of similar businesses. Companies with a larger gross profit margin are better equipped to keep spending under control. They will have better revenues based on how much they sell because they can control expenses, making this a more appealing investment.
A break-even analysis can be calculated using gross profit margin. A break-even analysis can reveal how much money a company needs to make to stay in the black, or how many units it needs to sell to stay in the black.
Carter McBride began writing for CMBA’s IP department in 2007. He’s written for the Bureau of National Affairs, Inc., as well as other publications and websites. For The Actual Impact of MasterCard’s Initial Public Offering in 2008, he earned a CALI Award. McBride has a Juris Doctor degree from Case Western Reserve University and a Master of Science in accounting from the University of Connecticut.