Gross margin, or gross profit margin, is the difference between revenue and cost of goods sold (COGS), divided by revenue. Gross margin is expressed as a percentage. Generally, it is calculated as the selling price of an item, less the cost of goods sold (e.g., production or acquisition costs, not including indirect fixed costs like office expenses, rent, or administrative costs), then divided by the same selling price. "Gross margin" is often used interchangeably with "gross profit", however, the terms are different: "gross profit" is technically an absolute monetary amount, and "gross margin" is technically a percentage or ratio.
Gross margin is a kind of profit margin, specifically a form of profit divided by net revenue, e.g., gross (profit) margin, operating (profit) margin, net (profit) margin, etc.
Purpose
The purpose of calculating margins is "to determine the value of incremental sales, and to guide pricing and promotion decision."
Percentage margins and unit margins
Gross margin can be expressed as a percentage or in total financial terms. If the latter, it can be reported on a per-unit basis or on a per-period basis for a business.
"Margin (on sales) is the difference between selling price and cost. This difference is typically expressed either as a percentage of selling price or on a per-unit basis. Managers need to know margins for almost all marketing decisions. Margins represent a key factor in pricing, return on marketing spending, earnings forecasts, and analyses of customer profitability." In a survey of nearly 200 senior marketing managers, 78 percent responded that they found the "margin %" metric very useful while 65 percent found "unit margin" very useful.
"A fundamental variation in the way people talk about margins lies in the difference between percentage margins and unit margins on sales. The difference is easy to reconcile, and managers should be able to switch back and forth between the two."
In contrast, "gross profit" is defined as:
or as the ratio of gross profit to revenue, usually as a percentage:
<math display="block">\text{Gross margin percentage} = \frac{\text{Revenue} -\text{COGS{\text{Revenue\times 100\%</math>
Cost of sales, also denominated "cost of goods sold" (COGS), includes variable costs and fixed costs directly related to the sale, e.g., material costs, labor, supplier profit, shipping-in costs (cost of transporting the product to the point of sale, as opposed to shipping-out costs which are not included in COGS), etc. It excludes indirect fixed costs, e.g., office expenses, rent, and administrative costs.
Higher gross margins for a manufacturer indicate greater efficiency in turning raw materials into income. For a retailer it would be the difference between its markup and the wholesale price. Larger gross margins are generally considered ideal for most businesses, with the exception of discount retailers who instead rely on operational efficiency and strategic financing to remain competitive with businesses that have lower margins.
Two related metrics are unit margin and margin percent:
<math display="block">\text{Unit margin} (\$) = \text{Selling price per unit} (\$) - \text{Cost per unit} (\$)</math>
<math display="block">\text{Margin} = \frac{\text{Unit margin} (\$)} {\text{Selling price per unit} (\$)} \times 100\%</math>
"Percentage margins can also be calculated using total sales revenue and total costs. When working with either percentage or unit margins, marketers can perform a simple check by verifying that the individual parts sum to the total."
In the agriculture industry, particularly with the European Union, Standard Gross Margin is used to assess farm profitability.
References
- "Relationship between Markup and Gross Margin"