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What Is Gross Margin?
Let me explain gross margin directly: it's the percentage of your company's revenue that you keep after subtracting the direct costs like labor and materials. This metric is crucial because it shows how effectively you're turning sales into profit before dealing with overhead and other expenses.
You calculate gross profit by taking revenue and subtracting the cost of goods sold. The higher your gross margin, the more money you retain from each sale, which you can then use for other costs or to pay off debts.
Key Takeaways
- Gross margin measures a company's gross profit compared to its revenues as a percentage.
- A higher gross margin means a company retains more capital.
- A company may cut labor costs or source cheaper suppliers if its gross margin drops.
- Gross margin focuses on revenue and COGS, unlike the net profit margin, which takes all of a business's expenses into account.
Formula and Calculation of Gross Margin
Here's the formula you need: Gross Margin = ((Net Sales - COGS) / Net Sales) × 100. Net Sales is basically your revenue, the total money from sales, possibly adjusted for discounts or returns. It's the top line on your income statement.
COGS includes direct costs like labor and materials for producing your products. For example, if your business brings in $200,000 in sales and spends $100,000 on manufacturing supplies, your gross profit is $100,000, and your gross margin is 50%.
What Gross Margin Can Tell You
Gross margin reveals the percentage of revenue left after COGS, calculated by dividing gross profit by sales. If you retain $0.35 from every dollar, that's a 35% gross margin.
Those remaining funds go toward debts, administrative expenses, interest, or dividends. You can use this metric to see how production costs stack up against revenues—if it's dropping, consider slashing labor or finding cheaper suppliers, or even raising prices.
It also helps measure efficiency or compare companies, regardless of their size.
Gross Margin vs. Net Margin
Gross margin looks only at revenue and COGS, but net margin includes everything—all expenses like distribution, wages, operating costs, and taxes. It's the percentage of net income from revenues.
Use gross margin to check manufacturing profitability, and net margin for overall business health, ensuring costs are controlled and profits are sufficient.
Gross Margin vs. Gross Profit
People often mix these up, but gross margin is a percentage, while gross profit is a dollar amount. Gross profit is revenue minus COGS, showing earnings after production costs.
Both come from the income statement and help gauge profitability, but the percentage gives a relative view.
How Do You Calculate Gross Margin?
To calculate it, subtract COGS from revenue to get gross profit in dollars, then divide by revenue and multiply by 100 for the percentage.
What's the Difference Between Gross Margin and Gross Profit?
Gross profit is the dollar figure after subtracting COGS from revenue, while gross margin is that figure as a percentage of revenue—both use the same inputs but express profitability differently.
What Is a Good Gross Margin?
It depends on the industry—service companies often have higher margins since their COGS is low, while manufacturers have lower ones due to higher production costs.
The Bottom Line
Gross margin, or gross profit margin, compares gross profit to revenue as a percentage, helping you spot inefficiencies and decide on cuts to boost profits. It's a solid tool for investors to evaluate if a company is worth investing in.
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