How to Compute a Gross Margin

Gross margin percentages help identify the most profitable product line

Gross margin is the difference between the sale price of an item and the cost to produce it, or the cost to purchase the item as inventory. Gross margin can be represented by the dollar-amount difference, but is most often reflected as a percentage difference so that one product line is easily compared to a completely different type of product. Business managers should calculate gross margin for individual product lines every month in order to identify the most profitable and unprofitable product lines. Gross margin information can then be used to make decisions about future production and product offerings.

Things You'll Need

• Sales revenue of product
• Manufacturing or purchase cost of product

Instructions

1. Obtain the total sales revenue for a product line. Do not deduct returns from the total sales revenue, as those items would have been placed back in inventory or written off as damaged.

2. Determine the total cost of manufacturing or purchasing the products that were sold. Manufacturing costs include the cost of all raw materials plus the costs associated with the manufacturing process, such as labor and utilities.

3. Subtract the total cost of manufacturing or purchasing the product from the total sales revenue for the product line to obtain the gross margin. For example, if a product line had monthly sales of $10,000 and a manufacturing cost of $3,000, the gross margin for the product line is $7,000.

4. Divide the gross margin calculated in Step 3 by the total sales revenue gained in Step 1 to obtain the gross margin percentage. For example, divide the gross margin of $7,000 by the total sales of $10,000 to obtain a gross margin of 70 percent.

5. Compare the gross margin percentage for every product line to determine the product lines that provide the most profit for the business. Higher gross profit margin percentages mean a higher profit margin on products. Whenever possible, underperforming product lines should be reduced or eliminated and replaced with more profitable products.

References

• "Principles of Accounting"; A. Douglas Hillman, Richard F. Kochanek, Corine T. Norgaard; 1991