How to Calculate Gross Margins From Sales to COGS

Low gross profits negatively affects cash flow from operations.

Gross margin is a simple but important calculation derived from a company's income statement. Expressed as a percentage, gross margin is a ratio that compares gross profit to revenue. Gross profit is the difference between revenue and cost of goods sold, or COGS. Both gross profit and gross margin calculations are used by company leaders to make decisions as to what, if any, action is needed to cut costs or raise market prices.

Things You'll Need

• Calculator

Instructions

Calculating Gross Profit

1. Add up all revenue for the period accounted for in your income statement. This includes all cash sales and accounts receivables. Show this as either "Revenue" or "Sales" as the first line item on your income statement.

2. Add up all variable costs. For a manufacturing company, this includes manufacturing costs such as direct materials and direct labor, along with the variable portion of manufacturing overhead, which includes indirect materials, lubricants, supplies and power, according to "Accounting for Management." For all companies, selling, general and administrative costs such as commissions, clerical costs, invoicing and shipping costs are also variable costs. Supplies, travel and clerical costs are also common variable costs for service organizations. Record all applicable variable costs as "Cost of Goods Sold" beneath revenue on your income statement.

3. Subtract costs of goods sold from revenue. Record the difference on the next line of the accounting statement as "Gross Profit." For instance, revenue of $1,000 minus costs of $500 equals $500 of gross profit.

4. Calculate the gross margin ratio. Take the gross profit amount and divide it by revenue. Using the previous example, take your $500 of gross profit and divide it by the $1,000 in revenue. The result is .5. To convert the gross margin to a percentage, multiple .5 times 100. This equals 50 percent.

5. Use the gross margin ratio in financial decision-making. If the gross margin percentage is relatively strong within your industry and compare to your goals, no change is likely needed. If margins are drastically low, leaders can cut variable costs or use marketing to drive up the perception of value in the marketplace.

Tips & Warnings

• Realize gross margin is only useful when comparing to your industry, competitors, previous periods and goals.

References

• BizWiz Consulting: Gross Profit Margin Ratio (Gross Margin Ratio)
• AccountingCoach; Income Statement: Part 4; Harold Averkamp
• Accounting for Management: Cost Classifications for Predicting Cost Behavior (Variable and Fixed Cost)