Gross margin definition

Gross margin, otherwise known as gross profit margin, refers to the company’s sales minus its costs of goods sold. The cost of goods includes direct labour costs, in addition to costs of materials used in producing or manufacturing the goods. It is expressed as a percentage of sales.

The higher the gross margin, the more revenue a company must cover its other outstanding obligations such as interest, debt, or taxes, to generate a profit. Since the cost of goods sold has already been considered, the remaining funds can be immediately channelled back into paying debts, general administrative expenses, fees, as well as dividend payments to shareholders.

Gross margin vs Gross profit

Gross margin and gross profit are both metrics that companies use to measure their profitability. They can be found on corporate financial statements, especially a company’s income statement. While they may be used interchangeably, these two metrics are not exactly the same.

Gross profit is simply the difference between a company’s sales and direct selling cost and is calculated by subtracting the cost of goods sold from the company’s revenue. In other words, it is how much money a company earns after factoring in sales and production costs. And while gross margin is expressed as a percentage, gross profit is usually expressed as a standard figure as a measure of absolute value.

Gross margin vs Net margin

Gross margin focuses solely on the relationship between the costs of goods sold and a company’s revenue. Net margin, or net profit margin, takes all of the business’s expenses into account and is the percentage of net income earned regarding the revenues received.

When calculating net margin, businesses also need to subtract other expenses such as product distribution, operating expenses, taxes, and even sales representative wages, to name a few.

Limitations to gross margin

While gross margin can be helpful in evaluating a company’s efficiency in converting sales to profit, there are still limits to the insights it can bring. For instance, gross margin may not be too effective as a metric to gauge the performance of companies in different industries. Some capital-intensive industries such as mining and manufacturing, often have a high cost of goods sold, which means relatively lower gross margins. On the other hand, other sectors like the tech industry have minimal costs of goods, and so typically produce high gross margins.

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