Gross margin is net sales less the cost of goods sold (COGS). In other words, it's the amount of money a company retains after incurring the direct costs associated with producing the goods it sells and the services it provides. The higher the gross margin, the more capital a company retains, which it can then use to pay other costs or satisfy debt obligations. The net sales figure is gross revenue, less the returns, allowances, and discounts.
KEY TAKEAWAYS
※Gross margin equates to net sales minus the cost of goods sold.
※The gross margin shows the amount of profit made before deducting selling, general, and administrative (SG&A) costs.
※Gross margin can also be called gross profit margin, which is gross profit divided by net sales.
What Does the Gross Margin Tell You?
The gross margin (also referred to as gross profit) represents each dollar of revenue that the company retains after subtracting COGS.
However, gross margin may also be referred to as gross profit margin. For example, if a company's recent quarterly gross profit margin is 35%, that means it retains $0.35 from each dollar of revenue generated.
Because COGS have already been taken into account, those remaining funds may consequently be channeled toward paying debts, general and administrative expenses, interest fees, and dividend distributions to shareholders.
Companies use gross margin, gross profit, and gross profit margin to measure how their production costs relate to their revenues. For example, if a company's gross margin is falling, it may strive to slash labor costs or source cheaper suppliers of materials.
Alternatively, it may decide to increase prices, as a revenue-increasing measure. Gross profit margins can also be used to measure company efficiency or to compare two companies of different market capitalizations.
The Difference Between Gross Margin and Net Margin
While gross margin focuses solely on the relationship between revenue and COGS, the net profit margin takes all of a business's expenses into account. When calculating net profit and related margins, businesses subtract their COGS, as well as ancillary expenses such as product distribution, sales rep wages, miscellaneous operating expenses, and taxes.
Gross margin helps a company assess the profitability of its manufacturing activities, while net profit margin helps the company assess its overall profitability.
What is a good gross margin?
The gross margin varies by industry, however, service-based industries tend to have higher gross margins and gross profit margins as they don't have large amounts of COGS. On the other hand, the gross margin for manufacturing companies will be lower as they have larger COGS.
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