Profitability indicator
Gross margin reveals how efficiently a company produces and sells its goods or services by showing what portion of revenue exceeds direct production costs.
The gross margin process
1
Revenue recognition
Sales are recorded when goods or services are delivered to customers.
2
COGS calculation
Direct costs-such as raw materials, direct labor, and manufacturing expenses-are tallied for the period.
3
Gross margin calculation
Subtract COGS from revenue and divide by revenue to express as a percentage.
4
Analysis and action
Management reviews gross margin trends to inform pricing, production, and sourcing decisions.
Impact on financial statements
Gross margin appears on the income statement, directly after revenue and COGS. It is a primary indicator of a company’s ability to generate profit from its core activities:
Higher gross margin: Indicates efficient production and/or strong pricing power.
Lower gross margin: May signal rising costs, pricing pressure, or inefficiencies.
Real-world examples
Case study: Retailer’s gross margin improvement
A retail company noticed its gross margin was declining due to rising supplier costs. By renegotiating supplier contracts and optimizing its product mix to focus on higher-margin items, the company improved its gross margin by 5 percentage points within a year, leading to increased profitability and stronger cash flow.
Frequently asked questions about gross margin?
Gross margin only considers direct production costs (COGS), while net profit margin accounts for all expenses, including operating costs, interest, and taxes.
It may signal rising production costs, falling sales prices, or operational inefficiencies.
By increasing prices, reducing production costs, or shifting focus to higher-margin products.