Why gross margin is important and how to calculate it

What is gross margin?

Gross margin is the result of subtracting the cost of goods sold from net sales. Gross margin may also be expressed as a percentage, which is often used when comparing businesses of different sizes and different industries. Companies want high gross margins, as it means that they are retaining more capital per sales dollar.

To determine their gross margins, companies must know how to calculate net sales and cost of goods sold (COGS).

Total revenue or net sales

Sales generate revenue, but not all goods or services sell at list prices. Sometimes, discounts are applied or allowances granted. Occasionally, products may be returned. The total sales revenue/net sales figure is gross revenue minus any financial concessions such as discounts, allowances, or returns.  

Cost of goods sold (COGS)

As companies create their products or services, they incur costs.  They may need to purchase raw materials or finished goods. Then, there's the labor that goes into making the product or delivering the service.  The total cost of labor and materials is the cost of goods sold.

Importance of understanding your gross margins

The gross margin is more than a number. It is a window into the financial health of a company. It measures production and business efficiencies. It can help with setting the selling price of a product and competitive analysis. Gross margins can identify potential problems before they hurt the bottom line.  

Gross margin gives critical information on production ROI 

Evaluating gross margins over time can help with cost control. Minor changes in gross margin can highlight problems in the supply chain. Has the cost of materials increased, or has a supplier upped its price?  Is it taking longer to deliver a service than anticipated? 

Processes may need to be adjusted to improve productivity. It's easy to overlook minor inefficiencies as long as margins are high, but a drop in gross margin could signal a decline in productivity. The more efficient production, the higher the margins. The higher the margins, the healthier the company.    

Gross margin helps inform pricing

Gross margins can be used to develop pricing strategies. Products are often priced based on market competition. Companies within a given market accept "standard" margins rather than explore pricing options.

Some businesses will decrease margins to increase gross sales in hopes of finding the perfect price point. Others will attempt to increase margins by setting higher prices, and marketing value adds. Careful analysis of gross margins can help triangulate the ideal pricing strategy to ensure higher profits and a healthy financial future.

Gross margin measures business efficiency

Gross margins can serve as a measure of company efficiency. If income statements are available on a monthly or quarterly basis, compare the gross margin figures. Are they staying steady? If margins are rising, that may be an indicator of improved efficiencies. A decline in gross margin may indicate inefficiencies. It can also indicate that lowering prices to increase sales is having a negative impact on financial stability.

Gross margin improves competitive analysis

Investors look at gross margin percentages to compare the profitability of companies from different market segments or industries. For example, analysts are looking at a manufacturing company and professional services groups for potential investment. Using the gross margin percentages from financial statements, analysts can determine any company's profit and learn which organization has stronger growth potential. High margins make it easier for companies to find additional funding.

Gross margin indicates growth potential

The gross margin amount indicates how much money a company has to invest in growing the business. If most of the gross profit is used to cover administrative expenses and operating costs, little money is available to enable growth. A lack of capital is one of the primary reasons that small businesses fail.

What is the gross margin formula?

Gross margin may appear as a dollar value or as a percentage, which means you can express gross margin with the following formulas:

The dollar formula Total Revenue – COGS = Gross Margin

The percentage formula is Total Revenue – COGS / Net Sales x 100

Both gross margin formulas are used depending on what metrics are being evaluated. Gross margin refers to the percentage value while gross profit may be used to indicate the dollar value.

How to calculate gross margin

Before you start to calculate gross margin, know that margins vary significantly from industry to industry. Grocery stores have very low margins, while SaaS subscription services have much higher margins. That's why to calculate gross margin, analysts often use the percentage formula to compare margins within and across industries.

Calculating gross margin (percentage)

A local manufacturer realized net sales of $500,000 over 12 months. The company spent $100,000 on materials and $200,000 in labor for a COGS of $300,000. Applying the percentage gross margin formula, the gross margin percentage is 40%.

(($500,000 - $300,000) / $500,000) *100

($200,000/$500,000) *100

0.4*100

40%

Calculating gross (profit) margin 

Although investors and analysts use percentages, the gross margin figure has more value for the business owner. Calculating gross margin tells companies how much money they have available to cover overhead costs, pay off debts, or deliver shareholder distributions.

Using the numbers from the manufacturing example, the gross margin calculation shows a gross margin of $200,000.

$500,000 - $300,000 = $200,000

The gross margin tells a business owner precisely how much money is available to cover all other expenses.

What is a good gross margin?

Gross margin ratios vary by industry. For example, technology companies show a gross margin of over 95% for the current quarter. Retail shows the lowest gross margin at just under 25% for the same period. Such wide variations in gross margin make comparisons outside of an industry meaningless to organizations within the industry. So what does a good gross margin look like?

Determining a good gross margin requires context. Take the retail sector as an example. At the end of last year, the gross margin hovered around 50%, making companies with a gross margin of less than 25% poor performing. Six months later, the highest performing companies are doing worse than the lowest-performing companies from a year ago. Tracking key performance indicators (KPIs) is the best way to determine financial health.  

For the last 12 months, the gross margin for technology has fluctuated between 50% and 56%.  The current quarter's margin is most likely the result of economic and health factors rather than a genuine improvement in efficiencies. In other words, the dramatic increase to 95% is the result of external factors that have driven up technology sales.

Companies within this sector should be tracking KPIs to compensate for the current uptick in sales. Without an understanding of the context around a gross margin, businesses can fail to recognize underlying concerns that should be addressed.

Improve gross margins by effortlessly reducing churn with Retain

How does a company improve its gross margin? Traditionally, companies work to increase sales and lower production costs. However, retaining customers can improve gross margins in companies that rely on recurring revenue from subscription or service agreements. Here's how retaining customers can improve gross margins:

• Spend less on customer acquisition costs
• Improve ROI and cash flow
• Increase sales

All of these impact a business's gross margin. And understanding your retention rates is crucial.   Retain can dramatically improve your retention rates, as well as win back lost customers.

Gross margin FAQs

How do you calculate gross margin?

Gross margin may appear as a dollar value or as a percentage.

• The dollar formula is: Total Revenue – COGS = Gross Margin
• The percentage formula is: Total Revenue – COGS / Net Sales x 100

What is the difference between gross margin and gross profit?

Gross profit is the monetary value that results from subtracting cost-of-goods-sold from net sales. Gross margin is the gross profit expressed as a percentage. It divides the gross profit by net sales and multiplies the result by 100.

Should gross margin be high or low?

The higher the gross margin, the healthier the company.