What is Gross Margin?

Picture a one-person food cart…

Calculating gross margin is like counting up the money you’d make if you were running that cart in a busy park and subtracting what you spent on supplies. You’d compare the amount of money that you made to the amount you spent on buying hot dogs and buns. You wouldn’t have advertising costs and wouldn’t be paying wages to anybody. Your gross margin is simply the difference between your sales and the costs of those ingredients.

Nailing down the terminology is key to understanding gross margin — and the first key related term is “revenue.” Revenue is all of the money that a company generates. It includes all of the cash that comes in from sales of products or services after any discounts or deductions are applied.

Other sources of income that aren’t associated with the selling of products or services are excluded from revenue. For example, if a company owns real-estate or other investments, and those investments bring in money, that income is not included. Sales revenue only includes income that comes directly from the sales of goods and services.

To continue using a hypothetical example: if a car company (let’s call it Rev) sells 10K cars at $75K a piece, the company’s revenue is $750 million. How much it costs to make those cars, advertise them, or pay sales people doesn’t change revenue — it’s purely a measure of the money that comes into the business.

Once you understand revenue, the next key term to focus on is “costs” — specifically, the “costs of goods sold” (aka COGS). You can calculate the cost of goods sold by adding all of the direct costs of a product, and multiplying it by the number of units of that product that customers bought.

This calculation includes both the materials involved in producing the product, as well as the direct labor costs of creating them. If the batteries, metal, leather, and rubber required to put together a car cost $50K, and the wages of the employees physically putting the car together cost $5K, the cost of goods sold for one car will be $55K.

The formula for calculating cost of goods sold for a single unit of a product is simply:

Cost of raw materials + cost of labor to produce = cost of goods sold

To calculate cost of goods sold for the entire company for a period of time, the formula is:

Value of inventory at the start of the period + inventory purchases + cost of labor directly involved in production - value of inventory at the end of the period = cost of goods sold for the period

Indirect costs related to the sale of goods, such as the wages paid to salespeople or the costs of research and development, do not play a part in the cost of goods sold.

To calculate gross margin, subtract the cost of goods sold for all of a company’s products from the company’s sales revenue, then divide that result by the company’s sales revenue.

For example, think about a hypothetical widget company. If the company sold $750M worth of widgets, which had a cost of goods sold of $550M, the company’s gross margin would be $750M - $550M = $200M. $200M/ $750M= 26.67%

That means that the company can use 26.67% of each sale of a widget for other business purposes. The remaining 73.33% is used to pay for the cost of producing the widget.

There are multiple “steps” in the margin chain, and gross margin is just the beginning. Gross margin isn’t the only type of margin that companies and investors calculate. Investors and companies use net margin, contribution margin, and standard margin for different purposes.

Net margin measures how much of a company’s revenue is left over after paying all of its expenses. This includes the cost of goods sold and indirect costs, such as taxes, administrative salaries, and so on.

To calculate net margin, subtract all of a company’s expenses from the company’s total revenue, then divide the result by the company’s revenue. This ratio can be used to measure a company’s overall profitability.

Contribution margin measures the revenues from a product minus all of the product’s variable costs.

Variable costs are the costs that scale with the number of products that are made. That’s different than fixed costs, which stay the same regardless of the number of products that the company makes.

One typical example of a variable cost is raw material required to produce an item, like the leather for a sneaker. One fixed cost would be the machinery used to produce that shoe, like a leather cutting device. Whether you build one or 100 widgets, the cost of the machine is the same.

To calculate contribution margin, subtract the variable costs of a product from the sales revenue that the product drew in, then divide the result by the sales revenue.

Standard margin is a measure of the money that is leftover from the gross margin after deducting an estimate of the company’s fixed costs. This can include expenses like utility bills, rent or property tax, wages, insurance, and maintenance.

Let’s say that in one month, a company spent $50K to produce products that later sold for $75K. The company’s gross margin would be $25K or 33.34%. If the company’s fixed costs amount to $20K, the standard margin would be just $5K or, $5K/ $75K = 6.67%.

Standard margin uses estimates of fixed costs, which is what differentiates it from net margin, which uses the actual costs. Standard margin doesn’t take unexpected expenses into account.

Gross margin is significant because it measures how much money is left over after producing and selling a product. This money can be put back into the company, helping it cover its other costs. The money can also be used to expand, pay down debts, or could be returned to the shareholders.

Gross margin can also be used to measure how production costs compare to revenues. If gross margins are decreasing, the company may raise prices or look for cost savings in the production process. If gross margins are increasing, that means the company may have more money available for other purposes. For example, if cotton gets more expensive, your favorite clothing chain’s gross margins will decrease. This might prompt them to increase prices or use a cheaper, lower quality material.

Investors care about gross margins because it shows whether a company can profit from selling its products. It also shows how efficient its production processes are and how much pricing power it has.

Higher gross margins can be an indicator of good things, but gross margin can't give you the full picture of a potential investment.