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For example, if you’re selling baby headwraps your cost of goods sold (COGS) could include raw materials like fabric, sewing materials, as well as direct labor—the wages of the employees who put it all together.
Things that aren’t included in cost of goods sold? Any other operating expense or indirect costs such as taxes, rent, insurance, and professional services.
Gross margin formula
The gross profit margin formula is as follows:
Gross Margin = (Total Revenue – Cost of Goods Sold) / Total Revenue
Let’s take a look at this income statement and calculate the gross margin:
If we plug revenue and cost of goods sold into our formula, we get:
$87,502 - $20,000 / = $87,502
Gross margin percentage = 0.77, or 77%
This tells us that our business is earning 77 cents profit for every dollar of its total sales. The company is selling its inventory for a higher profit than it costs to produce the product or service.
Differences between gross margin and gross profit
Gross margin and gross profit are often used interchangeably but there are a couple of key distinctions between the two.
As we can see from the example above, gross margin is expressed as a percentage and measures revenue that exceeds the cost of goods sold. In other words, it can show us how much revenue the business is holding onto after deducting its production costs.
Gross profit, on the other hand, is expressed as a whole dollar amount and shows us the revenue earned after subtracting the cost of goods sold:
Gross Profit = Revenue – Cost of Goods Sold
As we can see from the income statement above, the gross profit is a dollar value versus a percentage.
Why does gross margin matter?
A good gross margin allows you to pay for your operating costs and still generate a profit. When your gross margin is good, your net sales—the total amount of money you take home after taking all expenses into account—is also good.
It also shows how efficient the business is at producing and selling its products, and how profitable your product is.
Looking at last year’s gross margin figures and wondering if there’s any room for improvement?
The easiest way is to increase the price of your product or decrease the direct cost of goods (or both).
Raising the price of your product can be tricky to navigate—business owners often worry this will upset their current customer base. Research your industry: who else is selling baby headwraps? How are they pricing their products? If you do decide to increase the price of your product, you want to make sure you have the best baby headwraps on the market.
Alternatively, you can lower your cost of goods sold to improve gross margin. Is there a supplier who sells fabric at a lower cost than the one you currently buy from? If you purchase in bulk, are there any discounts you can take advantage of? Lowering costs is harder to do than raising prices, but keeps your customers happy.
Gross margin is only one aspect of your income statement. Investors will typically look at multiple metrics—operating expenses, net sales, cash flow, etc.—as well as other financial statements, in order to gain a larger understanding of your business and its financial health.
Further reading: To learn about other ways to measure your financial health, like net profit margin, check out our introduction to profit margin.
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