How to Calculate Gross Margin: Definition and Equation
Gross Margin = (Total Revenue – Cost of Goods Sold)/Total Revenue x 100. The answer is expressed as a percentage. The “Gross Profit Margin” shows the income a company has left over after paying off all direct expenses related to the manufacturing of a product or providing a service.
Here’s What We’ll Cover:
What Is Gross Margin?
Gross Margin is an indicator of whether a company is running an efficient operation and if its sales are good enough.
Gross Margin is also known as Gross Profit Margin. However, the term “Profit Margin” by itself may refer to any of the following margins:
Operating Profit Margin
Pre-Tax Profit Margin
Net Profit Margin
Each of these profit margins weigh the cost of doing business with or without certain costs factors. For instance, operating profit margin is calculated without interest or tax, while net profit margin considers all expenses related to the production of a product (it’s also known as “the bottom line”). For a detailed explanation of each profit margin, and how to calculate them, check out “How Do You Calculate Profit Margin for Your Startup”.
How Do You Calculate Gross Margin in Dollars?
Here is the calculation for gross margin in dollars:
Gross Margin = Revenue – Cost of Goods Sold.
Most businesses use a percentage. The formula to calculate gross margin as a percentage is:
Gross Margin = (Total Revenue – Cost of Goods Sold)/Total Revenue x 100.
Let’s use an example which calculates both.
Tina’s T-Shirts is based out of Carmel-by-the-Sea, California. Her business has not been in operation very long, only a year, and she wants to get a better idea of how much expenses are affecting her company’s profit. So, she calls up her accounting software and starts doing some calculations.
Her total revenue from sales is $400,000 for the year.
Her cost of goods sold is $325,000. Cost of goods sold includes the labor, materials and manufacturing overhead costs to produce her product (in other words, “direct costs”).
To calculate gross margin in dollars, she would do the following calculation:
Revenue – Cost of Goods Sold = Gross Margin $
$400,000 – $325,000 = $75,000
This means Tina has generated $75,000 in gross margin dollars.
Tina may need this number as a percentage. So now she redoes the calculation as follows:
(Total Revenue – Cost of Goods Sold)/Total Revenue x 100 = Gross Margin %
($400,000 – $325,000)/$400,000 x 100 = 18.75%
Tina’s t-shirt gross margin is 18.75%.
What Is a Good Gross Profit Margin?
In the example above, Tina is wondering if 18.75% is adequate. Should she be doing better? There are two considerations she needs to weigh:
Profit Margins Are Specific to an Industry
A high profit margin is one that outperforms the average for its industry. According to the Houston Chronicle, clothing retail profit margins range from 4 – 13% in 2018.
This means Tina’s business is doing exceptionally well with a 18.75% gross profit margin. Her business might be a model for other companies to follow. However, her store is in a prime tourist location, and she charges a heavy premium for her clothing. Those high prices would directly affect her gross profit margin.
Profit Margins Can Be Lower for a Startup
Profit Margins for a startup are generally lower because the operation is brand new, and it typically takes a while for efficiencies to be developed. However, Tina’s dad was a manufacturer of clothing too, so she knew a lot of the tricks of the trade already, before she went into business.
Regardless, there are likely ways she can improve efficiencies and perhaps realize even higher profits. Lately she has been thinking of expanding her line of clothing too. First, she needs to consider whether or not spending more money on labor and manufacturing to provide these new products will still give her the profit margin she currently enjoys. She may want to consider producing a small batch of the new clothing and see how those items sell first. Then run the numbers again to determine if the new clothing lines will be permanent additions.
What Business Has the Highest Profit Margin?
Services oriented businesses enjoy the highest profit margins. This is because they do not have the costs associated with manufacturing a product.
Why do some businesses manufacture products when clearly service oriented businesses enjoy more profits? Well, if the business is large, it could be due to volume. Larger businesses can move more, and realize more profits.
Why Should You Calculate Operating Margin?
Calculating gross margin allows a company’s management to better understand its profitability in a general sense. But it does not account for important financial considerations like administration and personnel costs, which are included in the operating margin calculation.
These indirect costs can really eat into a company’s profit, if not managed properly. Often administration and personnel costs are where management will make their first cutbacks, because those types of reductions will not affect a company’s core operations, which are vital to the survival of a business.