What is Gross Margin?
Gross margin is the sales revenue that a company retains after deducting direct costs associated with producing the goods and services it sells.
These direct costs are described as the cost of goods sold (COGS) and are an important cost metric for managers, decision-makers, and investors.
While gross margin is by no means the only cost metric that should be considered when analyzing a company’s profitability, it is a “quick and dirty” way to get an understanding of the profit margin of a company.
Exploring Gross Margin
Gross margin is easily calculated by deducting the cost of goods sold from the net sales revenue for the same period. The gross margin formula can be seen below.
Cost of goods sold information can be found on the income statement. If that information isn’t readily available, COGS information is easy to calculate.
Keep in mind that cost of goods sold calculations include only direct costs—we’ll get to that in a minute.
Cost of goods sold is calculated by adding purchases for the period to the beginning inventory for that same period, then subtracting the inventory at the period’s end, as shown in the cost of goods sold formula below.
Let’s say that ABC Corp has a starting inventory of $44,500 for the period.
In that same period, they purchased $8,700 worth of inventory and ended the period with an inventory number of $29,600.
Sales revenue for the period was $72,300.
By plugging the information we have into the COGS formula, we can calculate the cost of goods sold for this period.
In this instance, the cost of goods sold for ABC Corp is $23,600.
Calculating Gross Margin
Now that we have a COGS value, calculating gross margin is easy.
From the information included in our example, we know that ABC Corp reported net sales revenue of $72,300 for the period.
Plugging that number, along with the COGS value we calculated, into the gross margin formula will give us the result we are looking for.
Based on the calculation above, the gross margin for ABC Corp in this period is $48,700.
This can be expressed as the calculated number or as a percentage of the net sales revenue. In this case, the gross margin is just over 67 percent.
The Difference Between Gross Margin and Net Margin
Cost of goods sold calculations and, by extension, gross margin calculations, take only direct product costs into account.
Direct costs are those that can be tied directly to the production of products and services.
Indirect costs, on the other hand, include overhead costs such as office expenses, rent, utilities, and administrative costs.
These costs are not accounted for in a gross margin calculation, and therefore this calculation does not paint an accurate picture of a company’s costs. It is necessary to include both direct and indirect costs in the margin calculation to get a clear picture of a company’s costs.
When indirect costs are taken into account, this is known as net margin or net profit.
Net margin is calculated in the same way as gross margin but is expanded to include indirect costs as well.