Gross Margin: Definition, Example, Formula, and How to Calculate

What Is Gross Margin?

The term gross margin refers to a profitability measure that looks at a company's gross profit compared to its revenue or sales. A company's gross margin is expressed as a percentage. Gross profit is determined by calculating gross sales. The higher the gross margin, the more capital a company retains, which it can then use to pay other costs or satisfy debt obligations. The revenue or sales figure is gross revenue or sales, less the cost of goods sold (COGS), which includes returns, allowances, and discounts.

Gross Margin Formula and Calculation

$\begin{aligned} &\text{Gross Margin} = \text{Net Sales} - \text{COGS} \\ &\textbf{where:} \\ &\text{Net Sales} = \text{Equivalent to revenue, or the total amount} \\ &\text{of money generated from sales for the period. It can also} \\ &\text{be called net sales because it can include discounts} \\ &\text{and deductions from returned merchandise.} \\ &\text{Revenue is typically called the top line because it sits} \\ &\text{on top of the income statement. Costs are subtracted} \\ &\text{from revenue to calculate net income or the bottom line.} \\ &\text{COGS} = \text{Cost of goods sold. The direct costs} \\ &\text{associated with producing goods. Includes both direct} \\ &\text{labor costs, and any costs of materials used in producing} \\ &\text{or manufacturing a company's products.} \\ \end{aligned}$​Gross Margin=Net Sales−COGSwhere:Net Sales=Equivalent to revenue, or the total amountof money generated from sales for the period. It can alsobe called net sales because it can include discountsand deductions from returned merchandise.Revenue is typically called the top line because it sitson top of the income statement. Costs are subtractedfrom revenue to calculate net income or the bottom line.COGS=Cost of goods sold. The direct costsassociated with producing goods. Includes both directlabor costs, and any costs of materials used in producingor manufacturing a company’s products.​

To illustrate an example of a gross margin calculation, imagine that a business collects $200,000 in sales revenue. Let's assume that the cost of goods consists of the $100,000 it spends on manufacturing supplies. Therefore, after subtracting its COGS from sales, the gross margin is $100,000. The gross margin is 50%, or ($200,000 - $100,000) ÷ $200,000.

What Does Gross Margin Tell You?

A company's gross margin is the percentage of revenue after COGS. It is calculated by dividing a company's gross profit by its sales. Remember, gross profit is a company's revenue less the cost of goods sold. For example, if a company retains $0.35 from each dollar of revenue generated, this means its gross margin is 35%

Because COGS have already been taken into account, those remaining funds may consequently be channeled toward paying debts, general and administrative expenses, interest fees, and dividend distributions to shareholders.

Companies use gross margin, gross profit, and gross profit margin to measure how their production costs relate to their revenues. For example, if a company's gross margin is falling, it may strive to slash labor costs or source cheaper suppliers of materials.

Alternatively, it may decide to increase prices, as a revenue-increasing measure. Gross profit margins can also be used to measure company efficiency or to compare two companies of different market capitalizations.

Gross Margin vs. Net Margin

Gross margin focuses solely on the relationship between revenue and COGS. Net margin or net profit margin, on the other hand, is a little different. A company's net margin takes all of a business's expenses into account. Put simply, it's the percentage of net income earned of revenues received.

When calculating net margin and related margins, businesses subtract their COGS, as well as ancillary expenses. Some of these expenses include product distribution, sales representative wages, miscellaneous operating expenses, and taxes.

Gross margin helps a company assess the profitability of its manufacturing activities, while net profit margin helps the company assess its overall profitability. Companies and investors can determine whether the operating costs and overhead are in check and whether enough profit is generated from sales.

Gross Margin vs. Gross Profit

Gross margin and gross profit are among the different metrics that companies can use to measure their profitability. Both of these figures can be found on corporate financial statements, notably a company's income statement. Although they are commonly used interchangeably, these two figures are different.

As noted above, gross margin is a profitability measure that is expressed as a percentage. Gross profit, on the other hand, is expressed as a dollar figure. Gross profit can be calculated by subtracting the cost of goods sold from a company's revenue. As such, it sheds a light on how much money a company earns after factoring in production and sales costs.

The Bottom Line

There are different metrics to measure a company's profitability. The gross margin is just one of those figures. Gross margin, which may also be called gross profit margin, looks at a company's gross profit compared to its revenue or sales and is expressed as a percentage. This figure can help companies understand whether there are any inefficiencies and if cuts are required to address them and, therefore, increase profits. For investors, the gross margin is just one way to determine whether a company is a good investment.

Correction—Feb. 7, 2023: A previous version of this article defined gross margin incorrectly and used the wrong formula to calculate it. This was edited with the correct definition and formula.