Percentages rather than dollar amounts make a comparison between two companies more informative. You may be analyzing the performance of your own small business, or your business against a public company in the same industry, or you might be comparing two businesses you are considering acquiring. Know how the gross margin is calculated before you begin the comparison.
Revenue, or sales, is the first piece of information in calculating gross margin. Multiply the number of units sold times the price of the unit. Two companies may have the same level of sales -- $195,000, for example -- but different pricing. The first company sold 3,000 units at $65 per unit while the second company sold 2,500 units at $78. The difference in pricing affects the gross margin percentage.
Cost of goods sold is the second piece of information in calculating gross margin. The formula is beginning inventory plus purchases minus ending inventory. For example, if beginning inventory is $45,000, purchases are $75,000, and ending inventory is $30,000, the cost of goods sold is $90,000. Suppose two companies have the same sales level. If both companies also have the same cost per unit in inventory, the company with the higher price has a lower cost of goods sold, because it takes fewer units sold to reach that sales level. Cost of goods sold in a service industry is minimal since there is little to no inventory. There usually are no direct costs involved in providing marketing consulting, for example, so there would be no cost of goods sold. The expenses of the company would be reflected in general and administrative expenses, which include salaries. A service business that sells a product such as accounting software as part of its consulting services would recognize the wholesale price of the software as its cost of goods sold.
Revenue minus cost of goods sold equals gross margin. The gross margin percentage is the gross margin divided by sales for the same time period and expressed as a percentage. The percentage allows you to compare companies that have very different sales levels. For example, a company has sales of $250,000 and cost of goods sold at $130,000. The gross margin would be $120,000. Compare that to a company that has sales of $123,000 and cost of goods sold of $49,000. The gross margin is only $74,000 -- but the company with lower sales is actually doing better than the first company, because the first company's gross margin is 48 percent while the second company's gross margin is 53 percent. The gross margin for a service business is nearly the same, if not the same, as revenue. If the service business sells a product with its services, the gross margin is the difference between the price the company charges clients for the product and the product's wholesale price.
Different industries have different average gross margin percentages. If the two companies are in the same industry, then comparing the two gross margins is reasonable, but an adjustment has to be made if the two companies are in different industries. A service business, such as consulting, commonly has a very high gross margin. A retail business normally has a gross margin of about 50 percent, while an auto dealership usually has a low gross margin. One way to make the adjustment is to compare each company to the average gross margin in the relevant industry, and then to each other. For example, if the first company has a gross margin of 43 percent and the industry average is 30 percent, it's doing much better than the industry overall. If the second company under comparison has a gross margin of 60 percent, but the average of its industry is 70 percent, it's doing worse. The first company with the lower gross margin is actually performing better than the second company with the higher gross margin.
Another way to compare gross margin percentages is over time. Look at whether the margin percentages are improving or deteriorating. If there's an anomaly for one year, try to find out why. Perhaps there was an unusual event such as bad weather that negatively impacted sales, or perhaps the company took advantage of very low prices to increase its inventory at the end of the year.