Gross margin is a ratio of profit efficiency calculated after you know your gross profit for a given period. The gross margin formula, also known as gross profit margin, is your gross profit divided by your revenue. By understanding the gross margin definition, you can understand how to calculate your gross margin percentage to gauge your company's performance.
How to Calculate Gross Profit
Gross profit is the amount of money remaining after you subtract your variable costs or costs of goods (COGS) sold from the revenue you earned. COGS include such expenses as direct labor and production costs for a manufacturer, and acquisition, packing and shipping costs for a reseller. If you generated $400,000 in revenue, and had COGS of $175,000 for that same period, your gross profit is $225,000. The relationship between gross profit and gross margin is that your margin ratio calculation offers insight as to whether your gross profit is reasonable.
Companies need healthy gross profit to cover operating expenses, and to generate operating income, then net income. Keep the gross margin definition in mind to keep your calculations accurate.
Using the Gross Margin Formula
Unlike gross profit, gross margin is not expressed as a dollar value. The gross margin definition is this: a ratio comparing gross profit to revenue, expressed as a percentage. Use the gross margin formula to find this percentage, also known as the gross margin percentage.
If you generate $225,000 in gross profit for the period on $400,000 in revenue, you divide $225,000 by $400,000 to identify gross margin. In this case, your gross margin is 0.5625, or 56.25 percent. Thus, your business converted 56.25 percent of its periodic revenue into gross profit.
Assessing and Monitoring Gross Margin Percentage
Another core difference between gross profit and gross margin is that gross profit represents a periodic income value, whereas gross margin represents profit efficiency. A gross margin that is low relative to industry standards and your company's trend suggests the need to make adjustments to protect declining gross profit in the future.
While a relatively high gross margin is desired, industry norms vary due to cost structure and competition differences. Retail apparel, one of the highest-grossing retail sectors, had industry average margins ranging from 34 to 40 percent through 2014, according to CSIMarket Company. However, retail apparel was only #39 among S&P 500 companies in gross margin performance as of 2014. The key for a given business to be successful is to achieve above-standard gross margin percentages within their industry, and to see stable or improving margins over time.