What is Gross Margin?

Gross margin is a company’s net sales minus its cost of goods sold. The gross margin reveals the amount that a business earns from the sale of its products and services, before the deduction of any selling and administrative expenses. The figure can vary dramatically by industry. For example, a company that sells electronic downloads through a website may have an extremely high gross margin, since it does not sell any physical goods to which a cost might be assigned. Conversely, the sale of a physical product, such as an automobile, will result in a much lower gross margin.

The amount of gross margin earned by a business dictates the level of funding left with which to pay for selling and administrative activities and financing costs, as well as to generate a profit. It is a key concern in the derivation of a budget, since it drives the amount of expenditures that can be made in these additional expense classifications.

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Gross Margin Formula

As just noted, the formula for the gross margin is net sales less the cost of goods sold. It is better to use net sales than gross sales, since a large number of deductions from gross sales could skew the results of the calculation. Gross margin is frequently expressed as a percentage, called the gross margin percentage. The calculation is:

(Net sales - Cost of goods sold) / Net sales

For example, a company has sales of $1,000,000 and cost of goods sold of $750,000, which results in a gross margin of $250,000 and a gross margin percentage of 25%. The gross margin percentage may be stated in a company's income statement.

Gross Margin Analysis

The gross margin percentage is useful when tracked on a trend line, to see if there are any significant changes that may require further investigation. A decline in the gross margin percentage may be cause for considerable concern, since it can imply a decline in the competitiveness of a company's products and/or services in the marketplace.

Gross margin includes an allocation of factory overhead costs, some of which may be fixed costs or mixed costs. Because of the overhead cost inclusion, gross margin is not the same as contribution margin (which only reduces sales by the amount of any variable expenses incurred).

Gross margin analysis should be accompanied by a consideration of the rate at which inventory turns over. A high rate of inventory turnover combined with a low gross margin is the equivalent of a low rate of turnover with a high gross margin, from the perspective of total annual return on investment.

A strong case can be made that gross margin is not useful, since it does not focus on the ability of a company's production system as a whole to create throughput (which is sales minus totally variable expenses). Under this viewpoint, throughput is more important than gross margin, as is the utilization level of the bottleneck operation in a company.

The Difference Between Gross Margin and Net Margin

The essential difference between gross margin and net margin is that net margin also includes all other expenses not related to the cost of goods sold. Thus, administrative, selling, and financing expenses are factored into the net margin calculation. Net margin is useful for evaluating the overall profitability of an entity.

Presentation of Gross Margin

Gross margin appears on the income statement, immediately after the cost of goods sold line item and before the selling, general and administrative expenses section. If the business is a retailer, then the gross margin will instead be located after the cost of merchandise sold line item. A sample gross margin presentation appears in the following exhibit, which contains an income statement.