Gross margin definition
The portion of a company’s revenue left over after direct costs are subtracted.
Gross margin is one of the most important indicators of a company’s financial performance. It’s the portion of business revenue left over after you subtract direct costs, such as labour and raw materials.
“Companies should regularly be looking at their gross margin to make sure they’re creating economic value and see how they’re measuring up, vis-à-vis with their targets and industry peers,” says Sean Beniston, CPA, MBA, a Senior Client Partner at BDC Advisory Services who advises businesses on financial management.
“We all like to talk about net profit, but gross margin, truly speaking, is the first stage of analyzing financial performance. If you’ve not achieved that first step of profitable gross margin, it means you’re paying more to produce that good or service than you’re getting in additional revenue, which is not sustainable.”
What is gross margin?
Gross margin is the percentage of revenue left over after you subtract your company’s direct costs (i.e., the cost of producing or selling your goods or services). In a manufacturing company, these direct costs are called cost of goods sold (COGS); in retail and wholesale businesses, they’re known as cost of sales.
Gross margin (sometimes called gross profit margin) is not the same thing as gross profit. The latter is the amount of money left over after you subtract direct costs and is expressed as a dollar amount. Gross margin is expressed as a percentage.
How do you calculate gross margin?
Gross margin is calculated using the following formula:
Gross profit is calculated with this formula:
For example, in the sample income statement below, in Year 2, ABC Co. Ltd. had $1,100,000 in revenue, with a cost of goods sold of $730,000. In this case, the gross margin would be calculated as follows:
This means the gross margin was 33.6%.
How to calculate net income from gross profit
After calculating the gross profit, other costs are then subtracted to determine net income. Those include:
- selling, general and administrative expenses (SG&A), also known as indirect costs
- interest and depreciation
- the cost of non-operating items
- income taxes
Why is gross margin important?
While gross profit appears on an income statement, not all accountants or bookkeepers will also include gross margin.
“Both figures are useful,” Beniston says. “Knowing how much you have in terms of dollar amounts tells you how much is left to cover fixed and other costs. Meanwhile, knowing your gross margin on a percentage basis lets you see over a certain period and compare to other companies in your industry. Both are important pieces of information for an owner or financial manager.”
Gross margin is a key financial metric because it’s the first step in understanding the potential value of a company’s business model and how sustainable it will be.
“If your gross margin is negative, it’s a big red flag for an entrepreneur,” Beniston says.
Mistakes to avoid when calculating gross margin
It’s important to review your costs to make sure you’ve correctly accounted for them on your income statement. An accountant can provide guidance to your bookkeeper or controller on how to do this. It’s common for businesses to misallocate expenses, with the recording of labour expenses under COGS being one of the most frequent errors.
“It’s not likely that 100% of your employees’ time is spent making goods or providing a service,” Beniston says. “Recording all labour expenses under COGS understates your gross margin and could lead to bad decisions. COGS should only be the expenses you incur from making and selling that product or service.”
Correctly allocating expenses is essential in determining what drives your bottom line and for comparing yourself with industry peers. Mistakes can lead to unsound business decisions.
Take the example of a company that misallocates marketing and office salaries and records them under COGS, leading to its gross margin being understated. The company may then compare itself with an industry benchmark and find that its gross margin is lower than the average. This could lead the company to prioritize reducing manufacturing labour costs instead of focusing on areas that would have more impact on improving its performance.
“Having good, accurate information is the way to make sure you’re investing your time and energy in the right places,” Beniston says. “One of the biggest pitfalls in many small businesses is that management accounting is one of the last things that they think about. That may be the case because you’re focused on selling and operating. But, over time, you need to make sure your company is providing economic value so you can invest in growing the business or hiring more people, for example.”
Beniston cautions that it’s important to strike a balance between getting accurate figures and not over-burdening yourself with calculations. He recommends establishing a simple process to allocate costs, especially for smaller businesses or those with limited financial acumen. “You don’t want to spend all month trying to calculate granular COGS figures,” he says. “As your company matures and grows, you can build more robust controls and processes.”
Also important: If at some point you change how you allocate some expenses, you may not be able to easily compare gross margin values before and after the change. “You have to compare apples to apples,” Beniston says.
What’s the difference between gross margin and gross profit margin?
Gross margin and gross profit margin are identical.
What is a good gross margin for a company?
Average gross margins can vary significantly based on various factors, such as the typical expenses for a business in your industry. For example, those with heavy labour or raw material costs tend to have lower gross margins. Conversely, industries with significant R&D labour costs that are allocated to SG&A typically have higher gross margins.
The key is to compare your gross margin with similar companies. “If you are above the benchmark, that may be an indicator that you’re more efficient than your competition or you’ve got a brand that commands a higher price,” Beniston says. “If you’re right at the benchmark or below it, you can look at how you could do better.”
How should I use gross margin?
Gross margin is a key financial ratio that businesses should be regularly using to monitor their financial performance and enable sound business decision-making. Beniston says most businesses should calculate their gross margins “at least monthly.”
Entrepreneurs usually see their gross margin only when they receive year-end financial statements. But that may be too late. “Filing for taxes is different than running a business,” Beniston says. “One of the pitfalls of managing from your accountant-prepared statements is that you’re relying on potentially old information. If decisions are made early in your fiscal year that affect your profitability, 12 to 14 months can go by without you realizing its negative effects.”
Here are ways to use gross margin in your business:
1. Set a target. You can include a gross margin target in your strategic planning. For example, if your industry has an average gross margin of 55% and your company is at the average, you could strive to boost it to 60% over two years, then look at what decisions you can make to get there.
“If you’re measuring gross profit margins on a frequent basis, you can make decisions, almost in real time, that will help you propel your business forward and either avoid the pitfalls of lagging for too long or find ways to beat the industry average and become that industry leader,” Beniston says. “Gross margin can guide a lot of decision-making about the amount of cash you have left over to invest in equipment and growth. If you’re not keeping track of it, you’re flying a bit blind.”
2. Look at trends. You can compare gross margin over time to spot trends. Gross margin is a more useful indicator for this than gross profit. For example, your gross profit may go up in actual dollars, but it may make up a smaller portion of your revenue. “That could mean you’re becoming less efficient,” Beniston says.
“If your gross profit isn’t keeping up with increases in your revenue, you have the beginning of a problem. This is because for every product you produce after that, you’re making less money.”
What does a decrease in gross margin mean?
A decrease in gross margin could occur for several reasons:
- Revenue may have gone down and/or direct costs may have gone up.
- Revenue may have gone up, but direct costs went up more.
- Revenue may have declined, while direct costs didn’t decline by as much.
To home in on the cause, compare your numbers to previous periods. You may need to drill down deeper into specific revenue sources or cost items. It can be helpful to look at not only the absolute dollar figures for each item, but also their value as a portion of overall sales.
In the sample income statement above for ABC Co. Ltd., revenue went up from $1,000,000 to $1,100,000 between Year 1 and Year 2 and gross profit rose from $340,000 to $370,000, while gross margin remained the same at around 34%. Some costs went down as a portion of revenue, while others stayed the same or went up. For example, wages and benefits were $165,000 in Year 2, or 15% of revenue. That was slightly higher than in Year 1, when wages and benefits cost $145,000, or 14.5% of that year’s revenue.
“If you’re noticing over time that gross margins are shrinking, you need to look at the root causes—that will help you make decisions about how to adjust,” Beniston says.
Also look at gross margins in your industry and see how you compare. You may find that gross margins are falling industry-wide, from such things as rising material costs.
What does a gross margin of 50% mean?
A 50% gross margin means that for every dollar you gain in revenue, you spend 50 cents to produce that good or service.
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