Definition: Gross margin is revenues less the cost of goods sold. The gross margin reveals the amount that an entity earns from the sale of its products and services, before the deduction of any selling and administrative expenses. The figure can vary dramatically by industry. For example, a company that sells electronic downloads through a website may have an extremely high gross margin, since it does not sell any physical goods to which a cost might be assigned. Conversely, the sale of a physical product, such as an automobile, will result in a much lower gross margin.
The amount of gross margin earned by a business dictates the level of funding left with which to pay for selling and administrative activities, financing costs, and dividend payments to investors.
Gross margin is frequently expressed as a percentage, called the gross margin percentage. The calculation is:
(Sales - Cost of goods sold) / Sales
For example, a company has sales of $1,000,000 and cost of goods sold of $750,000, which results in a gross margin of $250,000 and a gross margin percentage of 25%.
This percentage is useful when tracked on a trend line, to see if there are any significant changes that may require further investigation. A decline in the gross margin percentage may be cause for considerable concern, since it can imply a decline in the competitiveness of a company's products and/or services.
Gross margin includes an allocation of factory overhead costs, some of which may be fixed or mixed costs. Because of the overhead cost inclusion, gross margin is not the same as contribution margin (which only reduces sales by the amount of any variable expenses incurred).
A strong case can be made that gross margin is not useful, since it does not focus on the ability of a company's production system as a whole to create throughput (which is sales minus totally variable expenses). Under this viewpoint, throughput is more important than gross margin, as is the utilization level of the bottleneck operation in a company.
Gross margin is also known as the gross margin percentage, gross profit or gross margin on sales.