What is gross margin?
Gross margin is a calculation that shows you how profitable your products/services are and is expressed as a percentage. It’s a fancy way of asking: how much money is left over from sales after you deduct the cost of making and selling your product/service?
For example, if you’re selling baby headwraps your cost of goods sold could include things like fabric, sewing materials, and 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 margin formula is as follows:
Gross Margin =
Revenue – Cost of Goods Sold
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
Gross margin = 0.77, or 77%
This tells us that our business is earning 77 cents profit for every dollar made. 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 productions 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.
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? What prices are they selling their product at? 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 profit, etc.—in order to gain a larger understanding of your business and its financial health.
Further reading: Income Statements, Explained