As such, you can think of gross margin as the percent of revenue left after all direct production costs.
The gross profit margin formula is gross profit divided by revenue.
Gross Margin = Gross Profit / Revenue
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.
Now that we know the definitions and formula, let’s work through several example calculations.
Company A Income Statement, Fiscal Year 2021
Company A Income Statement, Fiscal Year 2022
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 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.
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.
The operating profit margin formula is:
OPM = Operating Profit / Revenue
This metric looks at the profitability of the company during its normal course of business.
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.
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.
Track metrics like the top performing ecommerce stores.