How to Calculate Gross Margin

Gross margin or gross profit margin appears on the income statement every company must prepare each year.. The significance of this metric goes far beyond its place as part of the detailed description of a firm's revenue, expenses and profit. Gross margin is the amount a business has left to pay bills after the cost of the goods it sells is paid. As such, gross margin defines the limits every businessperson must take into account when preparing a budget.

The Gross Margin Metric

Gross margin is defined as the amount remaining after you subtract the cost of goods sold from net sales. Net sales means your company's actual revenue after adjusting gross sales for discounts, returns and missing or damaged inventory. The cost of goods sold is figured in slightly different ways, depending on the type of business.

Calculating the Cost of Goods Sold

For a retail operation, COGS is the cost of purchasing inventory for resale. If you run a manufacturing company, COGS is equal to the direct cost required to produce a good, including materials and direct labor. Be careful not to confuse gross margin with net margin.

Gross margin is the money available before operating expenses and financing costs are deducted.

Net margin is the amount remaining after these amounts are subtracted from gross margin.

Gross Margin Calculator

To determine gross margin, subtract the cost of goods sold from net sales. Suppose your net sales for the previous year total $2 million. The cost of goods sold was $800,000. Subtracting $800,000 from $2 million leaves a gross margin of $1.2 million.

Expressing the Margin as a Percentage

It is often useful to express gross margin as a percentage. For instance, if you want to compare the gross margins of two companies of different sizes, the gross margin percentage is a more appropriate and useful measure.

To determine gross margin percentage, divide the gross margin by net sales and multiply the result by 100. In this example, you would divide the gross margin of $1.2 million by net sales of $2 million and multiply by 100 to calculate the gross margin percentage. Here, it works out to 60 percent.

Gross margin percentages vary from industry to industry. A retailer typically has a small gross margin percentage, while an online business that markets downloadable apps may have a gross margin percentage approaching 100 percent since it does not sell a physical good that must be replaced.

Significance of Gross Margin

Gross margin is the figure that controls a firm's budget for the simple reason that it defines the amount of money available to pay administrative costs, sales and marketing expenditures and financing costs. Your company's gross margin and gross margin percentage can also provide other useful insights.

For example, if the gross margin percentage is higher or lower than that of similar firms, it may indicate a need to reevaluate your pricing structure.

If price increases change COGS, looking at related changes in gross margin will help you assess the impact of the changes. Finally, knowing gross margin helps you decide how much you can afford to commit to things like advertising and marketing.