Gross margin

Gross margin, gross profit margin or gross profit rate is the difference between the production costs excluding overhead, payroll, taxation, and interest payments and sales revenue. Gross margin can be defined as the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to cover overheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross profit and Cost COGS. It is a measure of how well each dollar of a company's input cost is utilized to cover the operational & Overhead expenses.

Investopedia defines Gross margin as:

Gross margin = (Revenue - Cost of goods sold) / Revenue

It can be expressed in absolute terms:

Gross margin = net sales - cost of goods sold + annual sales return

or as the ratio of gross profit to cost of goods sold, usually in the form of a percentage:

${\text{Gross Margin Percentage}}={\frac {\text{Revenue - COGS}}{\text{Revenue}}}*100\%$

Cost of sales (also known as cost of goods sold (CoGs)) includes variable costs and fixed costs directly linked to the sale, such as material costs, labor, supplier profit, shipping costs, etc. It does not include indirect fixed costs like office expenses, rent, administrative costs, etc.

Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income. For a retailer it will be their markup over wholesale. Larger gross margins are generally considered ideal for most companies, with the exception of discount retailers who instead rely on operational efficiency and strategic financing to remain competitive with lower margins.

How gross margin is used in sales

Retailers can measure their profit by using two basic methods, markup and margin, both of which give a description of the gross profit. The markup expresses profit as a percentage of the retailer's cost for the product. The margin expresses profit as a percentage of the retailer's sales price for the product. These two methods give different percentages as results, but both percentages are valid descriptions of the retailer's profit. It is important to specify which method you are using when you refer to a retailer's profit as a percentage.

Some retailers use margins because you can easily calculate profits from a sales total. If your margin is 30%, then 30% of your sales total is profit. If your markup is 30%, the percentage of your daily sales that are profit will not be the same percentage.

Some retailers use markups because it is easier to calculate a sales price from a cost using markups. If your markup is 40%, then your sales price will be 40% above the item cost. If your margin is 40%, your sales price will not be equal to 40% over cost (indeed it will be 60% above the item cost).

Markup

Markup can be expressed either as a decimal or as a percentage, but is used as a multiplier. Here is an example:

If a product costs the company $100 to make and they wish to make a 50% profit on the sale of the product (sale dollars) they would have to use a markup of 100%. To calculate the price to the customer, you simply take the product cost of $100 and multiply it by (1 + the markup), e.g.: 1+1=2, arriving at the selling price of $200.

The equation for calculating gross margin is: gross margin = sales - cost of goods sold

A simple way to keep markup and gross margin factors straight is to remember that:

1. Percent of gross profit is 100 times the price difference divided by the cost.
2. Percent of gross margin is 100 times the price difference divided by the selling price.

Gross margin (as a percentage of Revenue)

Most people find it easier to work with gross margin because it directly tells you how many of the sales revenue, or price, is profit. In reference to the two examples above:

The $200 price that includes a 100% markup represents a 50% gross margin. Gross margin is just the percentage of the selling price that is profit. In this case 50% of the price is profit, or $100.

${\frac {\$200-\$100}{\$200}}*100\%=50\%$

In the more complex example of selling price $339, a mark up of 66% represents approximately a 40% gross margin. This means that 40% of the $339 is profit. Again, gross margin is just the direct percentage of profit in the sale price.

In accounting, the gross margin refers to sales minus cost of goods sold. It is not necessarily profit as other expenses such as sales, administrative, and financial must be deducted.And it means companies are reducing their cost of production or passing their cost to customers. The higher the ratio, the better.

Converting between gross margin and markup (Gross Profit)

The formula to convert a markup to gross margin is:

${\text{Gross margin}}={\frac {\text{markup}}{(1+{\text{markup}})}}$

Examples:

• Markup = 100%; GM = [1 / (1 + 1)] = 0.5 = 50%
• Markup = 66%; GM = [0.66 / (1 + 0.66)] = 0.39759036 = 39.759036%

The formula to convert a gross margin to markup is:

${\text{Markup}}={\frac {\text{gross margin}}{(1-{\text{gross margin}})}}$

Examples:

• Gross margin = 0.5 = 50%; markup = [0.5 / (1 - 0.5)] = 1 = 100%
• Gross margin = 0.39759036 = 39.759036%; markup = [0.39759036 / (1 - 0.39759036)] = 0.659999996 = 66%

Using gross margin to calculate selling price

Given the cost of an item, one can compute the selling price required to achieve a specific gross margin. For example, if your product costs $100 and the required gross margin is 40%, then

Selling price = $100 / (1 - 40%) = $100 / 0.60 = $166.67

Differences between industries

In some industries, like clothing for example, profit margins are expected to be near the 40% mark, as the goods need to be bought from suppliers at a certain rate before they are resold. In other industries such as software product development, since the cost of duplication is negligible, the gross profit margin can be higher than 80% in many cases.