Gross margin is a company's revenue minus its cost of goods sold (COGS), divided by revenue, shown as a percentage. Cost of goods sold is what it directly costs to make or buy what was sold: materials, factory labor, the price paid for goods that are resold. A gross margin of 40% means that out of every 100 of sales, 40 is left after those direct costs, to pay for everything else (wages, rent, marketing, interest, tax) and, with luck, leave a profit. Gross margin comes before the running costs, so it sits above operating margin and net margin in the income statement.
Worked example
Company A sells $1,000,000 of goods in a year. Making them cost $600,000 in materials and factory labor. Gross profit = $1,000,000 - $600,000 = $400,000. Gross margin = $400,000 ÷ $1,000,000 = 40%. Company B, a store that resells goods, also has $1,000,000 of sales but pays $850,000 to buy them: gross profit is $150,000 and gross margin is 15%. B's number is lower, yet that alone says nothing about which company is better run, because a store and a maker of branded goods work with very different margins.
Why it matters
Gross margin shows how much room a company has between what it charges and what the product directly costs, which is the first thing to check about its pricing power and production efficiency. The figures come from the income statement in the annual report: revenue and cost of goods sold. The catch is that levels differ a lot by industry: a software company and a grocery chain can both be healthy at very different gross margins, and companies do not all put the same costs into cost of goods sold, so the line is not always like for like. A single low or high reading is a question to look into, not a verdict. Compare it with companies in the same industry and with the company's own past years, and watch for a margin that keeps drifting in one direction.
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Frequently asked questions
Gross margin = (revenue minus cost of goods sold) ÷ revenue, times 100 to get a percentage. With $1,000,000 of revenue and $600,000 of cost of goods sold, gross profit is $400,000 and gross margin is 40%.
There is no single good level, because it depends on the industry. Software and branded goods often show high figures, while supermarkets and distributors run on thin ones. Compare a company with similar companies and with its own earlier years.
Gross margin only subtracts the direct cost of making or buying the goods. Net margin subtracts everything: running costs, interest and tax as well. So the net margin is normally lower than the gross margin, and the gap between them shows how much the rest of the business costs.
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