Gross Margin

Gross margin is the amount by which a company's net sales exceed its cost of goods sold. It is often expressed as a percentage of net sales, in which case it shows how many cents of each sales dollar are left after paying for the goods or services sold, available to cover operating expenses, interest, taxes and profit. In everyday use the term can refer either to the dollar amount, which is the same as gross profit, or to the percentage, which some textbooks call the gross profit percentage or gross margin ratio.

Gross margin is one of the first figures analysts look at on an income statement, because it shows how well a company prices its products and controls its production or purchasing costs. It sits between revenue and operating income, before selling, general and administrative expenses are deducted. The broader concept of margins in economics and finance is covered in the entry on margin.

As a percentage, gross margin is calculated as:

Here $\text{Net sales}$ is gross sales less returns, allowances and discounts, and $\text{Cost of goods sold}$ is the cost of the products or services delivered to customers during the period, taken from the cost of goods sold line.

A sporting goods retailer reports net sales of $8,000,000 and cost of goods sold of $5,200,000. Its gross margin in dollars is $2,800,000, and as a percentage it is $2,800,000 divided by $8,000,000, which is 35 percent. If operating expenses are $2,000,000, operating income is $800,000, or 10 percent of sales. If the retailer can raise its gross margin to 37 percent through better buying, with the same sales and operating costs, operating income rises by $160,000, a 20 percent increase. Small changes in gross margin often have a large effect on the bottom line.

Gross margin reflects both pricing and costs. The main drivers include:

• Selling prices and discounting, including promotions, markdowns and the bargaining power of customers.
• Input costs, such as raw materials, purchased goods, freight-in, and direct labor and factory overhead for manufacturers.
• Product mix, since a shift toward higher-margin products raises the overall margin even if no individual price changes.
• Scale and efficiency, as larger volumes spread fixed production costs over more units and earn volume discounts from suppliers.
• Accounting choices, such as the inventory cost method and whether items like shipping or depreciation are included in cost of goods sold.

Gross margins vary widely by industry, so they are most useful when comparing a company with its own history or with close competitors. Software companies often report gross margins of 70 to 90 percent because the cost of delivering another copy of a program is very low. Branded consumer goods and pharmaceuticals also tend to have high margins. Grocery retailers, car makers and contract manufacturers usually operate on much thinner margins, sometimes 15 to 30 percent, and depend on high volumes. A company whose gross margin is falling over several years may be facing price competition, rising input costs or an unfavorable shift in its product mix.

Gross margin differs from the contribution margin, which subtracts all variable costs, including variable selling costs, but not fixed manufacturing overhead. It also differs from markup, which expresses gross profit as a percentage of cost rather than sales: a product that costs $65 and sells for $100 has a 35 percent gross margin but a markup of about 54 percent. Operating margin and net profit margin go further down the income statement. Because companies classify costs differently, analysts should check what each company includes in cost of goods sold before comparing gross margins, particularly in retail, where some firms include buying and occupancy costs and others do not. Comparing companies on a common-size income statement makes such differences easier to see.