Gross Margin

Gross margin is a profitability ratio that compares a company's gross profit to its revenue. Learn the formula and how to calculate gross profit margin.

What is Gross Margin?


Gross margin is gross profit divided by net sales revenue and shows how much profit, as a percentage, is left after covering variable costs. This ratio is also called gross profit margin.
Gross profit is net sales revenue less cost of goods sold (COGS). For an ecommerce company, net sales refers to gross revenue minus returns, refunds, deductions, and discounts; cost of goods sold refers to the cost paid for inventory.

As such, you can think of gross margin as the percent of revenue left after all direct production costs.

All businesses will want a higher gross margin, as this means there is more money left to cover fixed overhead, pay off debt, and generate a profit. All of these values are found on a company’s income statement.
Gross margin, also called gross profit margin, is gross profit divided by revenue.

Gross Margin Definition


The gross profit margin formula is gross profit divided by revenue.


Gross Margin = Gross Profit / Revenue


Revenue refers to all sales generated from selling products or services. Revenue is found at the top of the income statement.
Gross profit refers to revenue less COGS. Gross profit shows how much money is left after covering all variable costs. This amount can be used to cover fixed expenses.
Cost of goods sold (COGS) refers to all direct costs and direct labor associated with selling a product. For example, a manufacturing company will have to pay for raw materials, a factory, labor, shipping, import duties, and more in order to create finished inventory.
For product companies, careful inventory management will lead to higher gross margins and more efficient business operations. We recommend that companies keep track of their raw material costs and inventory turnover ratio.

A declining gross margin could mean that you are selling products for too cheap or offering too many discounts. A low inventory turnover could mean that inventory is sitting for too long, which is not a productive use of cash.

A high gross margin (a percentage closer to 100%) is better and means there are more resources for covering overhead and generating a profit.

A low gross margin (a percentage closer to 0%) is worse and could be a sign that a company does not have a good enough product or a strong marketing strategy.


Gross Margin Examples


Now that we know the definitions and formula, let’s work through several example calculations.


Company A Income Statement, Fiscal Year 2021

  • Revenue: $1,300,000
  • COGS: $570,000
  • OPEX: $610,000

Company A Income Statement, Fiscal Year 2022

  • Revenue: $2,300,000
  • COGS: $1,560,000
  • OPEX: $1,210,000

Please calculate the gross profit and gross margin for Company A.


2021 Gross Profit = Revenue - COGS

2021 Gross Profit = $1,300,000 - $570,000

2021 Gross Profit = $730,000


2021 Gross Margin = Gross Profit / Revenue

2021 Gross Margin = $730,000 / $1,300,000

2021 Gross Margin = 56.15%


The company generated a gross margin of 56% in 2021, which is low. Let’s run the numbers for 2022 to compare.


2022 Gross Profit = Revenue - COGS

2022 Gross Profit = $2,300,000 - $1,560,000

2022 Gross Profit = $740,000


2022 Gross Margin = Gross Profit / Revenue

2022 Gross Margin = $740,000 / $2,300,000

2022 Gross Margin = 32.17%


While the company added one million of revenue in 2022, they also added significant costs. Gross margin declined heavily to 32% – which makes it unlikely that this company can cover its overhead and turn a profit.

To increase gross margin, the company will need to have a higher gross profit. This can be achieved by increasing revenue, decreasing cost of goods sold, or both.


Gross Profit vs. Gross Margin


Gross profit refers to the money left after subtracting COGS from revenue. It’s expressed as dollars or another currency. In the example above, Company A had $730,000 of gross profit in fiscal year 2021.

Gross margin refers to the percent of revenue left after covering COGS. It’s expressed as a percentage, the same as all other margins. In the example above, Company A had a gross margin of 56% in fiscal year 2021.

These terms are closely related, but it’s important to keep the units correct.

Gross profit is expressed in dollars, whereas gross margin is expressed as a percentage.

Net Margin vs. Gross Margin


There are several types of profit margin. When discussing, it’s important to discuss the right margin and understand what each calculation is showing.

Gross Profit Margin


The gross profit margin formula is:


GPM = Gross Profit / Revenue


Gross margin is the percentage of revenue that is left after accounting for variable costs. It looks at the profitability of the products sold, not the business as a whole.


Operating Profit Margin


The operating profit margin formula is:


OPM = Operating Profit / Revenue


Operating margin is the percentage of revenue that is left after accounting for COGS and operating expenses (OPEX). OPEX is not dependent on revenue, such as rent, utilities, advertising, insurance, legal fees, interest payments, and other administrative expenses.

This metric looks at the profitability of the company during its normal course of business.


Net Profit Margin


The net profit margin formula is:


NPM = Net Profit / Total Revenue


Net margin is the percentage of revenue that is left after accounting for total revenue and total expenses. Total revenue is the sum of all operating and non-operating revenue. Total expenses is the sum of all operating and non-operating expenses.

The numerator is net profit, which is equivalent to net income. These terms can be used interchangeably. This metric looks at the bottom line: the profitability of the company at the end of the day, including variable, fixed, and irregular expenses.


Final Thoughts


Margins are metrics that are expressed as a percent of total revenue. Small business owners, executives, investors, and analysts all look to margins to understand the financial health of a business.

Companies can improve their margins by increasing price, decreasing costs, or improving their operational efficiency (e.g., making more revenue with the same expense structure).

Gross margin is gross profit divided by net sales revenue and shows how much profit, as a percentage, is left after covering variable costs. This ratio is also called gross profit margin.

Gross margin looks at the profitability of a company’s products, whereas net margin looks at the company’s profit across the entire business. All things equal, businesses want a higher gross margin as that means more money to cover overhead and to be left as profit.

Companies will need a careful understanding of their product costs, selling power, and marketing strategy in order to successfully generate profit. For example, some industries have low margins and high inventory turnover while others have high margins and low turnover.

A luxury watch manufacturer and the seller of AA batteries on Amazon will employ different strategies. That said, it is useful to compare gross margin across competitors within the same industries.

In almost all cases, a high margin is better than a lower margin. That said, startup companies or companies with a low price strategy might deliberately have low margins in order to grow quickly. That is a decision made by the company’s management and should be tracked carefully.

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