Gross Margin: Definition, Example Calculations, and Interpretation

Gross Margin: Definition, Example Calculations, and Interpretation

Gross Margin Definition: Gross Margin is the percentage of net sales that a company retains after paying for the direct costs of producing the goods and services it sells (known as COGS, Cost of Goods Sold, or Cost of Revenue).

If you have a company’s Revenue and COGS (“Cost of Goods Sold” or Cost of Revenue or Cost of Services or Cost of Products Sold or various other, similar names), the formulas to calculate the Gross Margin are straightforward:

Gross Profit = Revenue – COGS

Gross Margin = Gross Profit / Revenue

So, Gross Margin = (Revenue – COGS) / Revenue

The higher the Gross Margin, the more the company retains of each $1.00 in sales – meaning it can more easily pay for its fixed costs, including Operating Expenses such as employee salaries, rent, sales, marketing, and utilities.

The Gross Margin directly affects the breakeven point and breakeven formula for the company as well, which all factor into these points.

How to Calculate the Gross Margin

Calculating the Gross Margin is straightforward, but it requires precise data on Revenue and the Cost of Goods Sold (COGS). Here are the steps:

1) Determine the Revenue: This is the net sales figure before any expenses are deducted. It represents the gross sales generated from goods and services over a specific period, minus refunds, allowances, and reimbursements.

2) Find the Cost of Goods Sold (COGS): COGS includes all the direct costs attributable to the production of the goods a company sells. This includes the cost of the materials used to create the good and the direct labor costs used to produce the good. Most public companies disclose this a single line item on the Income Statement.

3) Calculate Gross Profit: You subtract COGS from Revenue to calculate this. Gross Profit is before operating expenses, interest payments, and taxes, so it represents what a company could potentially pay for these fixed and financial expenses.

4) Calculate the Gross Margin: Finally, you divide the Gross Profit by the Revenue and multiply by 100 to get the Gross Margin percentage.

Let’s illustrate this with a real-world example using Illinois Tool Works, a global multi-industrial manufacturing leader.

We’ll calculate the Gross Margin for three consecutive years to see if there’s a trend in operational efficiency:

In 2020, the Gross Margin = (12,574 – 7,735) / 12,574 = 41.3%.

In 2021, the Gross Margin = (14,455 – 8,489) / 14,455 = 41.3%.

In 2022, the Gross Margin = (15,932 – 9,429) / 15,932 = 40.8%.

The conclusion is that Illinois Tool Works’ Gross Margin hasn’t changed much over these three years.

There was a slight decrease from Year 2 to Year 3, but we’d have to look at longer-term data to say if that’s significant; reviewing peer company data would also help so we could benchmark the company.

If we go back to 2013, we can see from sources such as Capital IQ that ITW’s Gross Margin has always been between 39% and 42%, which is a very narrow range that indicates the company’s business model is not changing much over time.

It also indicates the company has a fair amount of pricing and market power since it appears to be able to raise its product prices in response to rising material and labor costs.

Nuances in Gross Margin

While the formula for Gross Margin seems straightforward, its calculation can get complex, particularly for small businesses or private companies where financial details might be less readily available.

One of the main issues lies in accurately determining the Cost of Goods Sold (COGS). COGS should reflect all direct costs related to product manufacturing or service delivery, but there’s a gray area in what companies decide to include, which can affect the Gross Margin.

For instance, inventory costs are a critical component of COGS for any company that sells physical products.

However, for businesses with fluctuating inventory levels or those using different accounting methods (FIFO, LIFO, or weighted average), the inventory cost can vary significantly, affecting the Gross Margin. Accurate inventory valuation is important to ensure that COGS reflects the true cost incurred in generating revenue.

Direct labor costs are another area requiring careful consideration. These costs should accurately reflect the expenses directly tied to the production of goods or services. Any misallocation between direct and indirect labor costs can skew COGS and, therefore, the Gross Margin.

For small/private companies and startups, where financial disclosures are less regulated, you need to review the company’s supporting data and budgets in detail to make sure the COGS and Gross Margin numbers are accurate.

What Does the Gross Margin Mean?

Gross Margin is an indicator of a company’s financial health and operational efficiency, and a higher Gross Margin is generally viewed more positively than a lower one.

However, the Gross Margin is also industry-dependent. For example, it is not unusual or impressive to see very high margins, such as 70%+ or 80%+, for industries such as software and branded pharmaceuticals.

That’s because these industries have substantial upfront development costs but require minimal direct costs for each unit sold, allowing for much higher Gross Margins.

Conversely, industries like retail or manufacturing, where the cost of sales includes raw materials and significant labor, usually have lower Gross Margins.

Therefore, you should always compare a company’s Gross Margins to the margins of similarly sized companies in the same industry (i.e., the comparable public companies) to understand the company’s profitability, operational efficiency, and cost management relative to its peers.

How Companies Can Improve Their Gross Margins

Companies can improve their Gross Margins via three main strategies:

1) Raise Prices – If a widget costs $10 to manufacture, but the company can charge $25 for it rather than $20 without impacting demand or unit sales, it can instantly boost its Gross Margin.

However, this is easier said than done because higher prices almost always affect demand for the product or service; this one tends to work only if the company’s offerings are currently underpriced or the company has a monopoly or other “moat” that protects it.

2) Cut Costs – The company might be able to negotiate better deals with suppliers, optimize production techniques, or use technology to streamline or automate the production process.

Efficient inventory management also plays a role, as excessive inventory can lead to increased holding costs, while too little can result in lost sales. Balancing these can significantly reduce COGS, thereby improving Gross Margin.

3) Introduce Higher-Margin Products/Services – For instance, a business might introduce digital products with low variable costs or value-added services that command premium pricing due to their unique benefits or exclusivity.

Gross Margins: Conclusions

The Gross Margin is critical in some industries and an afterthought in others.

From a financial modeling perspective, such as when you build 3-statement models or other forecasts, you normally assume that a company’s overall trend in Gross Margins continues into the future – unless the company plans to change its business model or operational profile.

If you’re completing a historical analysis, you should always go back at least ~10 years and compare a company’s Gross Margins to its previous numbers and to those of its closest peer companies to form an opinion about its profitability and operational efficiency.