Calculating gross margin involves two top line items found in a company's income statement: revenue and cost of sales.
Dominic Diongson; Canva
What Is Gross Margin?
Gross margin is the amount of money left over after subtracting the cost of sales from revenue. It is a simple and useful way to understand a company’s ability to generate profit from sales before additional deductions such as tax and administrative costs are made. The metric can indicate whether the company’s pace of sales is greater or less than the costs entailed in producing its goods. The term is also known as gross profit or gross income.
Gross margin is mainly applied to companies involved in the manufacturing of goods, such as cars, electronics, and food. Banks, for example, don’t use gross margin as a metric because they don’t make anything, and their income comes from the interest they make on loans. Instead, their version of gross margin would be net interest income, after accounting for interest expense.
Before going through gross margin in detail, understanding sales is necessary. Whenever a customer purchases a company’s product, that good is recognized as the sale of an item on the company’s books and is registered as income. Sales as a term slightly differs from revenue because sales refer to a company’s sale of goods, while revenue includes sales of both goods and services. For example, Tesla sells electric vehicles through its showrooms, but also separately provides services such as maintenance and repairs through its service centers where customers bring in their cars. Therefore, both sales of goods and services are recorded as revenue on its books. Still, sales are often interchangeable with revenue, and companies use either sales or revenue as a top line item.
A company’s cost of sales refers to the expenses involved in the manufacturing of goods. Those costs include the purchase of raw materials and labor. Like revenue, variations also appear as a line item: cost of goods sold, cost of revenue sold, etc.
Revenue and cost of sales can be found at the top of the company’s income statement. For publicly traded companies, look for the income statement in the quarterly and annual financial statements filed with the Securities and Exchange Commission.
Some companies make gross margin easy to recognize by listing it immediately after “Total Cost of Sales” (or revenue) within the top section of the income statement. It also may be listed under a different name, such as gross profit or gross income, but it’s not to be confused with gross profit margin, which is a profitability ratio that must be calculated separately.
How Is Gross Margin Calculated?
Gross margin is simply calculated by subtracting cost of sales from revenue.
Gross Margin = Revenue – Cost of Sales
How to Interpret Gross Margin
Using Apple as an example below, gross margin increased steadily over the five years leading up to 2021. (Note: Its fiscal year ends toward the end of September, different than the January–December calendar year for many companies.) Apple’s range of products varies—from iPhones, Macs, and iPads to its wearable devices. Its services include cloud and digital content such as the App Store and Apple TV, as well as online payment. The rate of gross margin from year to year was largely in line with the company’s growth in total sales, suggesting that executive management kept costs under control. It’s worthwhile to note that in its annual Form 10-K filings, Apple only started to include services as a separate item for revenue beginning in 2019—and backtracking the previous two years—probably realizing that services was becoming a major component of its revenue.
Gross margin is useful in the calculation of a profit margin metric known as gross profit margin, which is a profitability ratio that measures gross margin to sales.
Form 10-Ks; Figures, except for percentage change, are expressed in millions of dollars.
What are the Limitations of Gross Margin?
As its name implies, the gross figure is limited to the top line items of the income statement. Gross margin doesn’t include other expenses such as operating costs relating to advertising, marketing, research, and development or other costs related to the sales of its goods. Operating expenses would be used in the calculation of another metric called operating income. That type of income would be used in the calculation of a profitability ratio known as operating profit margin, which measures a company’s efficiency in generating income before interest expenses and tax payments are made.
While gross margin itself is a raw number, it’s better off being used in comparison to another line item. In this case, comparing gross margin to total sales–resulting in gross profit margin—provides additional clues on whether executive management was effective and efficient in managing profitability.
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about gross margin.
How Does Gross Margin Differ from Gross Profit Margin?
Gross margin itself is the difference between sales and cost of sales, while gross profit margin is the ratio of gross profit to total sales.
What Is a Good Gross Margin?
It’s difficult to assess what qualifies as a good gross margin. But if gross margin’s rate of change is greater than that of sales, it might indicate that the company has kept costs in check.
