Gross Margin Formula
The formula to calculate Gross Margin, often expressed as a percentage, is:
\(\text{Gross Margin} = \frac{\text{Total Revenue} – \text{Cost of Goods Sold}}{\text{Total Revenue}} \times 100\% \)
Where:
- Total Revenue is the total amount of money received from the sale of goods or services.
- Cost of Goods Sold (COGS) includes all the direct costs attributable to the production of those goods or services sold by the company. This typically includes direct labor costs and direct materials costs.
In this formula, you first subtract the COGS from the Total Revenue to get the Gross Profit. Then you divide the Gross Profit by the Total Revenue to get the Gross Margin Ratio. Multiplying by 100% expresses this ratio as a percentage.
The Gross Margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services it sells. A higher percentage indicates the company is retaining more on each dollar of sales to cover its non-production costs and/or generate profits.
Example of the Gross Margin Formula
Let’s take an example of a hypothetical company, “Best Bikes,” which manufactures and sells bicycles:
Suppose in the last fiscal year, Best Bikes had total revenue (total sales) of $2,000,000. The Cost of Goods Sold (COGS), which includes the direct costs for materials and labor used in creating the bicycles, was $1,200,000.
We can use the gross margin formula to calculate the gross margin:
- Calculate the Gross Profit: $2,000,000 (Total Revenue) – $1,200,000 (COGS) = $800,000 (Gross Profit)
- Calculate the Gross Margin: ($800,000 (Gross Profit) / $2,000,000 (Total Revenue)) x 100% = 40%
So, Best Bikes’ gross margin is 40%. This means that for every dollar Best Bikes earns from selling bicycles, it retains $0.40 after covering the direct costs associated with producing the bicycles. This remaining amount can be used to cover other business expenses like overhead costs, R&D, marketing expenses, or it can contribute to net profit.
