Gross Margin Definition

Gross margin is a company's net sales revenue minus its cost of goods sold (COGS). The gross margin represents the amount of sales revenue that the company retains after incurring the direct costs associated with producing the goods and services it sells. The higher the amount, the more the company retains on each dollar of sales to service its other costs and debt obligations. A firm's net sales is gross revenue less returns, allowances, and discounts.

$\begin{aligned} &\text{Gross Margin} = \text{Net Sales} - \text{COGS} \\ &\textbf{where:}\\ &\text{COGS} = \text{Cost of goods sold} \\ \end{aligned}$​Gross Margin=Net Sales−COGSwhere:COGS=Cost of goods sold​

To illustrate how to calculate gross margin, imagine a business collects $200,000 in sales revenue. Its cost of goods consists of spends $20,000 in manufacturing supplies and $80,000 in labor costs. After subtracting its COGS, it has a $100,000 gross margin.

The gross margin may also be calculated in percentage terms by dividing the gross margin number by net sales revenue. For example, dividing the gross margin by revenue equals 0.5, which multiplied by 100 gives a 50% gross margin.

The gross margin number represents the portion of each dollar of revenue that the company retains as gross profit. For example, if a company's gross margin for the most recent quarter is 35%, that means it retains $0.35 from each dollar of revenue generated.

The firm spends the remainder on operating expenses. As COGS have already been taken into account, the remaining funds can be put toward paying off debts, general and administrative expenses, interest expenses, and distributions to shareholders.

Companies use gross margin to measure how their production costs relate to their revenues. For example, if a company's gross margin is falling, it may look for processes that allow it to cut labor costs or for suppliers who offer lower costs on materials. Alternatively, it may decide to increase prices to boost revenue.

Businesses may also use gross margins to forecast how much money they have left over from sales to cover other operating expenses. For example, if a company has a 50% gross margin, it knows that it only has $0.50 of each revenue dollar collected to devote to operating expenses. Gross profit margins can also be used to measure company efficiency or to compare two companies of different sizes to each other.

While gross margin only looks at the relationship between revenue and COGS, net profit margin takes all of a business's expenses into account. When calculating net profit margins, businesses subtract their COGS as well as ancillary expenses, such as product distribution, wages for sales reps, miscellaneous operating expenses, and tax.

Gross margin, also called gross profit margin, helps a company assess the profitability of its manufacturing activities, while net profit margin helps the company assess its overall profitability. For related insight, read more about corporate profit margins.