What does gross margin measure?
Gross margin measures the amount of cash a business retains once the direct costs of producing and selling its goods and services are deducted from its sales revenue.
It costs money to make money, but companies must keep costs below revenue return if they want to make a profit. Gross margin is a measure of profitability, calculated as net sales less the cost of goods sold.
The metric is also known as gross profit margin or gross margin ratio. It is expressed as a percentage of revenue that a business keeps after subtracting direct expenses such as labour and materials.
We'll look more closely at this measure by investigating:
- How gross margin is calculated
- The difference between gross profit and gross margin
- How gross margin can be used
- What constitutes a 'good' gross margin
- The limitations of gross margin.
How to calculate it
Gross margin is calculated by taking total sales (revenue), deducting the cost of goods sold (COGS), and expressing this figure as a percentage of revenue. That is why it is sometimes referred to as the gross margin percentage.
The gross margin formula is:
Gross margin = Total revenue – cost of goods sold / revenue
Let's look at an example. Say a company makes sales of $10 million in a year. The cost of manufacturing and supplying its products is $6 million a year. This means its gross margin will be 40%. This is the proportion of each dollar revenue the company retains after subtracting the cost of selling its goods.
So if a company has a gross margin of 40% in the most recent reporting period, it retained 40 cents of each dollar of revenue after paying for COGS.
Funds retained after paying the costs of sales can be used to make payments on debt, pay for business development and administrative expenses, and as profits that can be paid to shareholders as dividends.
Gross margin is one of three main profitability ratios, the others being operating profit margin and net profit margin. It is arguably the most important, as a business will not remain viable without a high enough gross profit margin.
We can calculate gross profit margin from a company's income statement, which will list total sales revenue and expenses, including COGS. A high gross margin indicates a company makes more money from producing and selling its goods or services than it costs to produce them. This is a good sign for overall profitability.
Gross margin vs. gross profit: What's the difference?
To calculate gross margin, you also need to calculate gross profit, and the terms frequently need to be clarified. The formula for gross profit is simply revenue minus COGS.
Gross profit = total revenue – cost of goods sold
It is a measure of absolute value, given in dollar figures, while gross margin is the gross profit ratio divided by revenue, given as a percentage. Therefore, gross margin ratios provide a context absent from gross profit figures.
Of course, a company will need to make a gross profit to be profitable. However, the higher the gross margin, the more money a company will have to cover its obligations outside the direct selling costs. These could include interest, tax, and business development expenses.
How to use gross margin to evaluate a company
Companies use gross margin to measure how production costs relate to revenues. If a company sees gross margin falling, it may seek to lower production costs to protect gross margin. Alternatively, it could increase prices to boost sales revenue. Gross margin provides insight into a business's ability to control its production costs. All else being equal, a higher gross margin should flow into improved profitability.
Gross margin indicates how efficiently a company produces revenue given its production and selling costs. Investors can use this metric to compare companies, noting that gross margins vary across industries.
Some, such as service-based industries, tend to have higher gross margins as the cost of their inputs are minimal. Others, such as manufacturing companies with significant COGS, inevitably have lower gross margins.
Measuring changes in a company's gross margin over time can give insight into whether its operations are becoming more or less efficient. Calculating the gross margins of multiple companies in the same industry can help you determine which has the most efficient operations. Gross margin is less helpful in comparing companies across different sectors, given it will be impacted by the industry's capital intensity.
What is a good gross profit margin?
What constitutes a good gross margin varies across industries. A gross margin of 50% to 70% would be considered healthy for many businesses, such as retailers and manufacturers. But a gross margin of 50% may be regarded as low for other industries, such as technology. Service sector firms with lower production costs can achieve gross margins in the 90%+ range.
Gross margin can tell you whether a particular business is outperforming the industry benchmark or improving its production efficiency over time. Business owners and managers may use it to set targets and monitor progress over reporting periods. As revenues grow, COGS should also increase, but if COGS grows faster than revenue, the ability to remain profitable is jeopardised.
New companies and start-ups usually have lower gross margins because they have not developed the efficiencies that mature companies generate over years of operation. Alternatively, they may have above-average gross margins if the owners do not take full payment for their work.
What are the limitations?
Gross margin is an important ratio, but it does not tell you everything you need to know about a business. Other profitability measures, which account for costs of running the company outside of direct selling costs, can provide more insight into overall profitability. These include the net profit margin, which accounts for interest and taxes.
It is essential to get gross margin right, but it is just one of several metrics investors will look at when analysing a stock. Other key metrics include the price-to-earnings (P/E ratio), price-to-book (P/B ratio), earnings per share (EPS), and market capitalisation.
These metrics all help prospective investors build a picture of the prospects of an ASX-listed share, but none are decisive in isolation.
Ultimately, shareholders want their shares to turn a profit, allowing them to collect returns in the form of dividends. Gross margin will not be positive if operating expenses exceed revenues. The gross margin calculation can help investors determine how efficiently a company generates revenues, which in turn meet the costs of doing business and allow for profitability.
