Gross Margin Definition
Mathematically, gross margin can be represented as,
Gross Margin = Net Sales Revenue − COGS.
In simple terms, the gross margin is an indication of the amount of sales revenue that the company is able to retain as profit after paying off the costs incurred during the production of goods sold or the delivery of services. It should be noted here that COGS is exclusive of costs such as operating expenses, interest payments and various taxes.
The gross margin helps in the calculation of derivative profitability ratios such as the Gross Margin Ratio (also known as the gross profit margin ratio), which is obtained by dividing the Gross Margin by the total Revenue, and the result expressed as a percentage of net sales.
Gross Margin Ratio = Gross Margin / Net Sales Revenue.
A Little More on What is Gross Margin
In simple terminology, gross margin represents the difference between the cost to produce or acquire an item and its selling price. It can be noted here that by the above definition, gross margin is the exact same as gross profit. However, the term gross margin is often used as a synonym for the gross margin ratio, and as such, gross margin is expressed as a percentage in such instances. When expressed as a percentage of sales, the gross margin represents the portion of each dollar of sales revenue that the business retains as gross profit. Thus, if a business reports a gross margin of 40%, it means that it has retained $0.40 from each dollar of sales revenue.
It should be borne in mind that gross margin is fundamentally different from profit margin, and does not include deductions such as selling, general and administrative (SG&A) expenses and interest expenses.
The concept of gross margin can be better illustrated with a simple example. Suppose a company makes $100,000 in sales revenue from sales of food processors. It spends a total of $50,000 during the production of the food processors — split as $20,000 spent on raw materials and $30,000 on labor. In this case, $50,000 will be the cost of goods sold (COGS). From the above data, the company’s gross margin can be calculated as
Gross Margin = $100,000 – $50,000 = $50,000.
Similarly, the gross margin ratio can be calculated as
Gross Margin Ratio = $50,000 / $100,000 = 0.5 or 50%.
Usage of Gross Margin
The primary utility of the gross margin is as a metric to determine the relation between the production costs incurred by a business and its revenue. A falling gross margin can either be an indicator of higher-than-normal production costs or lower-than-normal sales revenue. There are usually two ways to ameliorate sinking gross margins — (1) Cutting costs associated with labor or procurement of raw materials (2) Increasing prices of the finished products or services.
Secondly, the gross margin is often used by businesses to estimate the amount of funds left over from sales that could be used to cover other operating expenses. Thus, a business that manages a gross margin (ratio) of 40% has a maximum of 40 cents out of every dollar of sales revenue that it can allocate towards operating expenses.
Lastly, gross margin can be utilized as a metric to measure the efficiency of a business or during comparisons of financial performance between two separate businesses.