- Gross margin is the amount of profit a company has left after deducting the cost of goods sold (COGS) from the revenue generated by selling those goods. It’s expressed as a dollar amount.
- The gross margin ratio is the percentage of revenue left over after subtracting COGS. It’s the gross margin expressed as a percentage, and it illustrates how much of a business’s revenue is spent on producing the goods it sells and how much is available to spend on operating expenses such as administrative costs.
What is gross margin?
Gross margin, also referred to as “gross profit” or simply “the margin,” is the difference between what a business sold to customers (revenue or net sales) and how much it cost to make the thing they sold them (cost of goods sold/“COGS”). Here’s the formula used to calculate gross margin:
Gross margin = Revenue (or net sales) – Cost of goods sold
Gross margin represents the amount of profit a company has left over to pay for operating the overall business, after subtracting the costs of creating the thing they are selling. To correctly calculate gross margin, you have to understand what counts as cost of sales and what doesn’t.
Cost of sales includes every ingredient that went into a good or service that is sold, which may include both physical components of the good as well as the wages of the people who actually assembled it. Things such as The CEO’s salary, office supplies, administrative costs, research and development (R&D), and employee travel expenses are not considered costs of sales. Rather, these are considered to be operating expenses or overhead costs.
Example of gross margin
Consider Apple’s 2018 consolidated statement of operations. Apple reported the following totals (rounded for ease):
- Total revenue (referred to as “net sales”) of $265 billion
- Total COGS of $164 billion
- Gross margin of $101 billion.
How to improve gross margin
Gross margin is influenced by the components of its formula: revenue and cost of sales. If you increase revenue by raising the price of your goods or services, while keeping cost of sales the same, your gross margin goes up. If your cost of sales is increased, perhaps by increasing costs of parts or labor, but your revenue stays the same, gross margin goes down.
To improve gross margin, a business must:
- Reduce cost of sales
- Increase selling price for goods or services
Difference between gross margin and gross profit margin
Gross profit margin is a financial ratio that takes gross margin and divides it by total revenue, to show the portion of revenue spent on COGS. It’s expressed as a percentage and calculated using this formula:
Gross profit margin = Revenue – COGS / Revenue
In the Apple example cited above, the company’s gross profit margin is 38%.
($265 billion – $164 billion) / $265 billion = 38%
Gross profit margin is an indication of a business’s profitability, based on the percentage of revenue it spends to make products or deliver services. But remember, gross profit margin shows only one aspect of profitability, and it does not account for the percentage of revenue spent on operating expenses.
What do gross margin and gross profit margin tell you about a business?
When someone asks, “Is that a high-margin or low-margin business?”, what they’re asking is: How much of the business’s revenue is spent on making the product or delivering the service? Is the product expensive to make compared to the revenue generated by selling it? And how much revenue is left over to pay for other things, like operating expenses?
Let’s return to the Apple example. Apple’s gross profit margin was 38% in 2018. This is good, but not as good as Facebook’s 2018 gross profit margin, which was 83%. Note that Facebook represents cost of sales as “cost of revenue” on their income statement.
Facebook’s 2018 gross profit margin = ($55,838 — $9,355) / $55,838
What this tells us about the two businesses is that Apple spends a lot more on making their products than Facebook does—which makes sense, when you consider what the two companies sell.
For the most part, Facebook’s COGS include hosting their website and some customer support. Apple, on the other hand has to maintain a complex supply chain, source hardware parts, and assemble computers and phones. Of course Apple is going to have a much higher cost of sales and much lower gross margin when looking at it as a percentage of revenue.
What this doesn’t tell you is which business is more profitable. To assess that, you have to factor in expenses to the business beyond cost of sales, including operating expenses. That’s why true profitability assessments factor in both gross profit margin and operating profit margin.
Difference between gross margin and unit economics
A company’s gross margin on the income statement is an aggregate of all the products the company sells. But each product line might have a different margin—this is “unit economics.” For example, iPhones will certainly have a different margin than, say, a gigabyte of Apple’s iCloud storage.
Difference between gross margin and net margin
While gross margin is limited in scope, focusing specifically on revenue and cost of sales, net margin takes into account all costs associated with running a business, including overhead.
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