Gross Margin Guide: How to Calculate Gross Profit Margin

Gross margin, also known as gross profit margin or gross margin ratio, refers to a company's net sales revenue, or total revenue, minus its goods, services, and interest expenses. One of the most detailed and frequently used financial ratios in corporate finance, the formula for calculating gross margin can be an important metric for companies to measure the profitability of their production, manufacturing, and overall operating costs.

The gross margin provides a percentage for business owners and shareholders to understand the amount of money available to distribute to factors like debt, dividends, and other expenses, and how efficiently they produce a product (in the case of a small business) or multiple projects, as is the case with larger entities.

The purpose of gross profit margin is to show business owners how much they profit from each dollar of revenue earned from sales of the company’s product and what funds they can use for debt, expenses, administrative expenses, interest fees, and dividends to shareholders.

Gross margin also provides a picture to business owners of how production costs affect their total revenue. If their gross margin is depreciating, they may need to revisit cash flow projections, change their pricing levels, cut costs, or find cheaper raw materials for production and manufacturing.

To calculate your gross margin, you’ll need your net total sales and cost of goods sold, which you can find on your income statement. In the formula, net sales refer to total or gross revenue minus returns and discounts listed on the top line of the income statement.

Cost of goods sold (or COGS) is the direct costs specifically tied to the production or manufacture of a product, like labor or the cost of raw materials. What qualifies as COGS varies according to the source, but in most cases, it does not include operating expenses or indirect costs like taxes or professional services.

To calculate the gross margin, use the following formula on a balance sheet:

N (Net sales) - C (Cost of Goods Sold) ÷ N = Gross Margin

Subtract the net sales from the cost of goods sold, then divide the difference by the total net sales. The quotient, or answer, is the gross margin when expressed in a percentage.

Here's an example that illustrates the gross margin formula:

Sally’s Salmon Company reported net sales of $229 million for the fiscal year ending September 30, 2020, in its consolidated statements of operations. Sally also reported COGS of $141 million.

Subtracting $229 million from $141 million and then dividing the difference by the net sales amount of $229 million resulted in a total, when presented as a percentage, was 38%. Sally’s Salmon Company earned 38 cents in gross profit for every dollar generated in total sales before other business expenses were expended.

The difference between gross margin and profit margin comes down to business expenses. Gross margin only focuses on the impact of COGS on revenue.

Profit margin, also known as net profit margin, involves all business-related expenses. Companies subtract their total expenses (including production, distribution, taxes, and operating expenses) from their total revenue to calculate net profit.

Ultimately, gross margin provides a bottom line on the profitability of a company's production and manufacturing, while profit margin provides a detailed picture of the company's overall profitability.

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