A:

The direct cost margin is calculated by taking the difference between the revenue generated by the sale of goods or services and the sum of all direct costs associated with the production of those goods, divided by the total revenue.

Expressed as a percentage, the direct cost margin indicates what portion of each revenue dollar is retained as profit after accounting for only those expenses incurred for the production of goods and services. The direct cost margin is often referred to as the gross margin, and is an important metric in corporate finance.

Depending on how revenue and expense data are labeled on company financial documents, this margin can be expressed two ways:

Direct Cost Margin = (Revenue - Direct Costs) / Revenue

or

Gross Margin = (Revenue - Cost of goods sold) / Revenue

What Are Direct Costs?

Direct costs are expenses that can be directly linked to items for sale. For manufacturers, this includes raw materials such as lumber, paint, hardware and the cost of labor needed to build each item. For retail operations, direct costs include the price paid to the wholesaler or manufacturer and any commissions paid to salespeople.

Depending on the operation, it may also include supervisor salaries if the presence of the supervisor is directly and uniquely beneficial to the production or sale of goods. The salaries or wages of employees whose roles are not intrinsically linked to the production or sale of goods are not included as direct costs.

Direct costs are also referred to as the cost of goods sold, or COGS.

Measuring Operational Profitability

The direct cost margin is an excellent indicator of whether a company's most basic expenses are eating into its net profits. A low direct cost margin means relatively little revenue is left over to cover all the other expenses a business incurs in its day-to-day operations. A weak gross margin can easily trickle down to a less-than-impressive net profit margin.

Keeping direct costs down is a crucial component of maintaining a healthy bottom line.

RELATED FAQS
  1. What is the difference between gross margin and operating margin?

    Understand the difference between gross margin and operating margin in relation to evaluating a company's overall profitability ... Read Answer >>
  2. What's the difference between profit margin and operating margin?

    Learn the differences between a company's gross profit margin, net profit margin and operating margin, and what each profitability ... Read Answer >>
  3. What is the difference between operating margin and contribution margin?

    Understand the difference between two measures of profitability, operating margin and contribution margin, and the purpose ... Read Answer >>
  4. What is the difference between gross margin and net margin?

    Learn the basics of gross profit margin and net profit margin, including how each is calculated and interpreted as a metric ... Read Answer >>
  5. What is prime cost in managerial accounting?

    Learn about prime costs in managerial accounting such as direct material cost, labor and wages cost, and other direct costs ... Read Answer >>
  6. What is the formula for calculating gross profit margin in Excel?

    Understand the basics of the gross profit margin including its interpretation as a measure of profitability and its calculation ... Read Answer >>
Related Articles
  1. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  2. Investing

    A Look At Corporate Profit Margins

    Take a deeper look at a company's profitability with the help of profit margin ratios.
  3. Managing Wealth

    What’s a Good Profit Margin for a New Business?

    Surprisingly, the younger your company is, the better its numbers may look.
  4. Investing

    Understanding Marginal Cost of Production

    Marginal cost of production is an economics term that refers to the change in production costs resulting from producing one more unit.
  5. Managing Wealth

    What's a Good Profit Margin for a Mature Business?

    How to determine if the amount you clear dovetails with the competition.
  6. Investing

    Key Financial Ratios for Manufacturing Companies

    An investor can utilize these financial ratios to determine whether a manufacturing company is efficient, profitable and a good long-term investment option.
  7. Trading

    Margin Trading

    Find out what margin is, how margin calls work, the advantages of leverage and why using margin can be risky.
  8. Investing

    Profitability Indicator Ratios

    Learn about profit margin analysis, effective tax rate, return on assets, return on equity and return on capital employed.
RELATED TERMS
  1. Contribution Margin

    Contribution margin is a cost accounting calculation that tells ...
  2. Gross Profit

    Gross profit is the profit a company makes after deducting the ...
  3. Gross Profit Margin

    A financial metric used to assess a firm's financial health by ...
  4. Adjusted Gross Margin

    Adjusted gross margin is a calculation used to determine the ...
  5. Gross Income

    Gross income is the total income from all sources before deductions ...
  6. After-Tax Profit Margin

    After-tax profit margin is a financial performance ratio calculated ...
Hot Definitions
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  2. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  3. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  4. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  5. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  6. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
Trading Center