Gross Margin
What Is Gross Margin?
Gross margin is the difference between a product’s selling price and its cost of production.
Gross margin is expressed as a percentage of the selling price.
For example, if a company sells a product for $100 and it costs the company $90 to produce the product, the gross profit would be $10 ($100 minus $90) and the margin would be 10 percent ($10 divided by $100).
Gross Margin Formula
The formula for gross margin is:
Gross Margin = Net Sales − COGS
How Is Gross Margin Used?
Gross margin is used to measure a company’s financial health and profitability.
A higher gross margin indicates that a company is efficient in its production process and is able to generate more revenue with less overhead.
Conversely, a lower gross margin indicates that a company is not as efficient and may be struggling to generate profits.
Investors often use gross margin as one metric to assess a company’s overall financial profile.
What Are Some Other Metrics That Measure Profitability?
There are a number of other metrics that measure profitability, including gross profit margin, operating margin, and net profit margin.
Gross profit margin is gross margin expressed as a percentage of revenue.
Operating margin is operating income expressed as a percentage of revenue.
Net profit margin is net income expressed as a percentage of revenue.
Gross Margin vs. Gross Profit
Gross margin is closely related with gross profit.
Gross profit is the difference between a product’s selling price and its cost of production.
Gross margin is gross profit expressed as a percentage of sales or selling price of a specific item (e.g., the gross margin on a certain model of vehicle produced by an automaker).
Gross margin is a more precise metric because it takes into account the selling price of a product, while gross profit does not.
Gross Margin vs. Operating Margin
Gross margin is sometimes confused with operating margin.
Operating margin is a measure of a company’s profitability that takes into account all expenses, including both production costs and overhead.
Gross margin only takes into account production costs, not overhead.
While gross margin and operating margin are both measures of profitability, they are not the same.
Operating margin is a more comprehensive metric because it takes into account all expenses, while gross margin does not.
Gross Margin vs. Contribution Margin
Gross margin is often confused with contribution margin.
Contribution margin is the difference between a product’s selling price and its variable costs of production.
Variable costs are those costs that change in proportion to the number of products produced.
Fixed costs are those costs that do not change in proportion to the number of products produced.
For example, if the price of your product is $100 and the unit variable cost is $40, then the unit contribution margin is $60.
Gross margin is a more precise metric than contribution margin because it takes into account both fixed and variable costs, while contribution margin only takes into account variable costs.
Gross Margin vs. Net Margin
Net margin is net income expressed as a percentage of revenue.
Net income is gross margin minus all expenses, including both production costs and overhead.
For example, if a company has gross margin of $30,000 and expenses of $27,000, its net income would be $3,000 ($30,000 minus $27,000), and its net margin would be 10 percent ($3,000 divided by $30,000).
While gross margin and net margin are both measures of profitability, they are not the same.
Net margin is a more comprehensive metric because it takes into account all expenses, while gross margin does not, taking into account only cost of goods sold (COGS).
Gross Margin Ratio
The gross margin ratio is a financial metric used to assess a company’s financial health and profitability.
The gross margin ratio is calculated by dividing gross margin by revenue.
For example, if a company has a gross margin of $30,000 and revenue of $100,000, its gross margin ratio would be 30 percent ($30,000 divided by $100,000).
A higher gross margin ratio indicates that a company is more efficient and is able to generate more profits.
Conversely, a lower gross margin ratio indicates that a company is less efficient and may be struggling to generate profits.
Gross Margin Percentage
The gross margin percentage is another financial metric used to assess a company’s financial health and profitability.
The formula to calculate gross margin as a percentage is:
Gross Margin = (Total Revenue – Cost of Goods Sold)/Total Revenue x 100
A higher gross margin percentage indicates that a company is more efficient and is able to generate more profits.
Conversely, a lower gross margin percentage indicates that a company is less efficient and may be struggling to generate profits.
What Is a Good Gross Margin?
There is no one answer to this question as it depends on the industry in which a company operates.
Some industries have higher gross margins than others.
They can vary even within industries depending on the type of business.
For example, the gross margin for a company that manufactures luxury cars is likely to be higher than the gross margin for a company that manufactures mass-market cars.
Investors should compare a company’s gross margin to its industry average of all comparable companies to get an idea of how efficient the company is.
A company with a gross margin above its industry average is considered to be more efficient than its peers, while a company with a gross margin below its industry average is considered to be less efficient.
The gross margin is a financial metric that measures a company’s profitability.
It is calculated by dividing gross margin by revenue.
A higher gross margin indicates that a company is more efficient and is able to generate more profits.
What Is the Difference Between Gross Margin and Markup?
Gross margin should not be confused with markup.
Markup is the difference between a product’s selling price and its cost, but it is expressed as a percentage of the cost.
For example, if a product costs $100 and is sold for $200, the markup would be 100 percent ($200 – $100 divided by $100).
The gross margin, on the other hand, is the difference between a product’s selling price and its cost, but it is expressed as a percentage of the selling price.
For example, using the same numbers as above, the gross margin would be 50 percent ($200 – $100 divided by $200).
Markup and gross margin are both measures of profitability, but they are not the same.
Gross margin is a more accurate measure of profitability because it takes into account all expenses, while markup does not.
Adjusted Gross Margin
Adjusted gross margin is a metric used to determine the profitability of a product, product line, division, or company.
The adjusted gross margin includes the cost of carrying inventory, whereas the (unadjusted) gross margin calculation does not take this into consideration.
Inventory carrying costs can vary widely from one company to the next, and they can have a significant impact on profitability.
For example, let’s say Company A has gross margin of 40 percent and inventory carrying costs of 2 percent.
Company B has gross margin of 40 percent and inventory carrying costs of 10 percent.
Both companies have the same gross margin, but Company A is more profitable because its inventory carrying costs are lower.
To calculate adjusted gross margin, simply subtract the inventory carrying cost from the gross margin.
In our example above, Company A would have an adjusted gross margin of 38 percent (40 percent – 2 percent), while Company B would have an adjusted gross margin of 30 percent (40 percent – 10 percent).
As you can see, the adjusted gross margin is a more accurate measure of profitability than gross margin because it takes into account all expenses, including inventory carrying costs.
Gross Margin Return on Investment (GMROI)
Gross margin return on investment (GMROI) is a metric used to evaluate the profitability of a company’s products.
It is calculated by dividing gross profit by the inventory cost.
GMROI looks at a firm’s ability to turn its inventory into cash above the cost of its inventory.
GMROI is also commonly known as the gross margin return on inventory investment (GMROII).
It is an inventory profitability evaluation ratio that is most commonly referenced in the retail industry.
Limitations of Gross Margin
Gross margin is a useful metric, but it has its limitations.
Doesn’t take into account all expenses
First of all, gross margin only tells us about a company’s profitability at the gross level.
It doesn’t take into account all of the other expenses that a company incurs, such as selling, general, and administrative (SG&A) expenses.
To get a more accurate picture of a company’s profitability, you need to look at net margin, which takes into account all expenses.
Manipulation
Another limitation of gross margin is that it can be manipulated.
For example, a company might artificially inflate its gross margin by using aggressive accounting methods or by cutting costs in areas that are not essential to the quality of the product.
To get a true picture of a company’s gross margin, you need to adjust for these kinds of accounting shenanigans.
For instance, an automaker might cut its warranty reserve to give the illusion of higher gross margin (and gross profit) on its vehicles and move the actual warranty expenses into other accounts.
This type of accounting trick works until its unit growth stalls.
Gross margin varies by industry
Finally, gross margin can vary widely from one industry to the next.
For example, gross margins in the retail industry are typically lower than gross margins in the tech industry.
This is because retailers generally have higher costs associated with inventory and employee labor. Some tech companies, on the other hand, may not deal with physical products at all and have no cost of goods sold.
Gross margin is a useful metric, but it’s important to keep its limitations in mind.
How a Company Can Increase Its Gross Profit Margin
There are a few ways that a company can increase its gross profit margin.
First the obvious – one way is to increase prices or decrease costs.
Costs can be decreased by negotiating better deals with suppliers, improving manufacturing processes, or automating tasks.
An additional way to increase gross profit margin is to mix and match products in a way that maximizes gross margin.
For example, a retailer might sell high-margin items alongside low-margin items in order to reach its desired gross margin percentage.
Many companies will also offer add-ons to increase average order value.
For instance, an airline will offer up-sells like priority boarding, better seating, in-flight entertainment, WiFi, etc.
The gross profit margin on these add-ons can often be 100 percent or more, which can help to offset lower gross margins on the core product.
There are a number of ways to increase gross profit margin. The most effective approach will vary from company to company, and it’s usually a combination of several different strategies.
Gross Margin – FAQs
What is gross margin?
Gross margin is a metric used to evaluate the profitability of a company’s products.
It is calculated by dividing gross profit by revenue.
What is the difference between gross margin and markup?
Markup and gross margin are both measures of profitability, but they are not the same.
Gross margin is a more accurate measure of profitability because it takes into account all expenses, while markup does not.
What is a good gross profit margin?
A good gross profit margin will depend on the industry.
For example, gross margins in the retail industry are typically lower than gross margins in the manufacturing industry.
What is gross margin return on investment (GMROI)?
Gross margin return on investment (GMROI) is a metric used to evaluate the profitability of a company’s products.
It is calculated by dividing gross profit by the inventory cost.
What are the limitations of gross margin?
The limitations of gross margin include that it only tells us about a company’s profitability at the gross level and that it can be manipulated by accounting tricks.
Additionally, gross margin varies widely from one industry to another.
What’s the gross margin formula?
The gross margin formula is: Gross Margin = (Revenue – COGS) / Revenue.
What’s an example of how gross margin would be calculated?
An example of gross margin would be if a company had $100 in revenue and $80 in COGS. The gross margin would be (100-80)/100, or 20 percent.
What’s the gross margin percentage?
The gross margin percentage is the ratio of gross profit to revenue. It is calculated by dividing gross profit by revenue and multiplying by 100.
For example, if a company had gross profit of $50 and revenue of $100, the gross margin percentage would be 50 percent.
GROSS PROFIT MARGIN: A Simple Explanation
Summary – Gross Margin
Gross margin is a metric used to evaluate the profitability of a company’s products. It is calculated by dividing gross profit by revenue.
There are a few ways that a company can increase its gross profit margin, such as increasing prices, decreasing costs, or by mixing and matching products in a way that maximizes gross margin.
Gross margin is a useful metric, but it’s important to keep its limitations in mind.
These limitations include that it only tells us about a company’s profitability at the gross level and that it can be manipulated. Additionally, gross margin varies widely from one industry to another.