Definition: Gross margin, often called gross profit, is a financial ratio that measures how well a company can control its costs. The gross margin formula is calculated by subtracting cost of good sold from the net sales during a period.
What Does Gross Margin Mean?
This is a key profitability calculation that managers can use to show how well their department or the entire company is doing for a period. It measures the amount of revenues left over after all of the costs associated with the revenues have been paid.
In other words, the gross margin is the amount of profits left over after all of the cost of goods has been paid. Think of it in terms of a retailer. Total inventory sales revenue minus the cost of the revenue equals the gross margin. The operating and other expenses can then be subtracted from the gross margin to arrive at the bottom line net income for the year.
Since it uses both the revenues and cost figures, management can assess trends even with fluctuating sales from year to year.
Take Bill’s Retail Store for example. Bill had net sales of $1,000,000 from inventory that cost him $750,000. Bill’s gross margin for the year is $250,000. This means that after all of Bill’s inventory, or cost of good sold, was paid off, he profited $250,000.
The next year Bill only had sales of $800,000, but he managed to keep his costs to $600,000. Bill’s margin for the second year is $200,000.
Although Bill is less profitable in year two, he maintained the same efficiencies and achieved the same gross margin ratio for the period. In this sense, Bill’s business is not doing “worse.” It’s just shrinking in size.