Definition of gross margin: A ratio expressing gross profit as a percentage of revenue. Gross margin is also known as gross profit margin.
How to calculate gross margin
Here’s an example of how gross margin is calculated:
Cost of sales: (£50)
Gross profit [revenue less cost of sales] = £100 – £50 = £50
Gross margin [gross profit divided by revenue] = £50/£100 = 50%
What is gross margin?
The gross margin ratio shows what percentage of revenue remains as a surplus after you cover the direct costs of generating the revenue.
Gross margin represents the profits which will contribute towards overhead costs and profit. It is usually quoted in GAAP compliant accounts.
Gross margin as a % is expected to remain constant if volume rises or falls. This is because both of the components of the calculation (revenue and cost of sales) are directly linked to the number of units sold.
In this way, gross margin can be a real asset to analyst making forecasts. As it can indicate how profitable a company could become if it increases the scale of its operations, or if it were to remove or add products to its line-up.
Find out more about analysing the gross profitability of individual product lines in the best management accounting books.
How is the phrase gross margin used in a sentence?
“The gross margin percentage on all product lines rose from 30% in last years financial statements, to 34% this year.”
“If we can source cheaper parts from an overseas supplier, the impact at the gross margin level will be significant.”
“We formed our budget based on an expected gross margin of 24%.”
What else you should know about gross margin
Gross margin is sometimes confused with ‘gross mark-up’.
Mark up is the ratio which shows gross profit as a proportion of the cost of sales. It’s showing how the business charged over and above what it spent.
Margin shows gross profit as a share of revenue, i.e. what proportion of revenue becomes gross profit.
In the sample earlier, with £100 revenue and £50 cost of sales, we calculated that the gross margin was 50%. I.e, the company retained 50% of its sales price after covering the cost of sales.
Mark-up is calculated as gross profit divided by cost of sales, expressed as a percentage. In this example, it would be £50 gross profit / £50 cost of sales = 100% mark-up.
Said another way, the company charged a 100% mark-up of £50 on top of its cost of sales.
How does the definition of gross margin relate to investing?
Gross margin is useful for fundamental analysis and value investing because it provides a quick measure of how ‘lucrative’ a business model is.
The gross margin of popcorn sold at cinemas is known to be close to 99%, this means that almost every penny spent by customer translates into gross profit for the cinema chain.
High volume businesses usually don’t aim to make a large gross margin on their sales. The gross margin for supermarket chains is usually less than 10%.
This is because their revenue figure is high enough that even a small gross margin percentage translates into enough gross profit cover the overheads of the business and provide a return to investors relative to the capital they originally invested as equity.