What Is Gross Margin Percent?

Gross margin is one of several profitability ratios.

Gross margin is a basic computation expressed as a percentage of sales. It is an important financial ratio for small business owners, managers and company executives who want to gauge their company's profitability, operating efficiency and pricing strategy. Wall Street analysts focus on profitability ratios, including gross margin, when looking at the operating performance of publicly held companies.

Calculation

Gross margin is calculated as: sales - cost of goods sold/sales x 100. For example, given sales of $1,000,000 and cost of goods sold of $750,000, a retailer's gross margin is 25 percent. What it says is that for every $1 worth of sales, after taking into consideration its selling costs, the retailer keeps 25 cents. Ideally, the higher the gross margin, the better.

Comparisons

A good practice is to compare gross margins over different time periods, such as year-over-year or over previous quarters, to spot any noticeable trends. Ideally, you want to see stable or sequential increases in gross margin. As an investor, looking at gross margins across companies is one way to compare a company's operating performance. A 25 percent gross margin may be considered good for some businesses but not for others. A company that produces higher gross margins is considered more efficient than its competitors.

Considerations

In general, companies in the same business (all else being equal) should have similar gross margins. However, a company may have above average gross margins compared to its peers. Therefore, it is important to analyze the components of gross margin and why one company's gross margin is better than its peers. If a company's sales comprise higher margin goods or services relative to its peers, then its gross margin should be higher.

Costs

While sales is an important component of the gross margin calculation, the level of costs of good sold is equally important. You want to see a stable increase in costs of goods sold more in line with sales growth. Increasing sales and declining costs of goods sold will produce higher gross margins. Higher costs of goods coupled with slowing sales will produce lower gross margins.

Insight

Gross margins should stabilize over time, particularly for mature companies. Therefore, fluctuations or spikes in gross margins should be a warning sign to investors. Gross margins will vary for companies, depending on their business strategies. For example, gross margin will be lower for a discount retailer compared to that of a high-end retailer. Some industries will produce above average gross margins, such as the software development industry.

References

• Calculator Plus: Financial Ratio Calculator