What is Gross Margin Formula?
Gross margin is derived by the deducing Cost of Goods Sold (COGS) from the Net Revenue or Net Sales (Gross Sale reduced by discounts, returns, and price adjustments), and when the result is divided by revenue, we can arrive at the gross profit percentage. The formula of gross margin in numbers and in percentage term is as follows:
Explanation
- Gross Sales: Revenue or sales is the amount fetched by the company after selling its services or goods. Generally, all the major companies follow the accrual method of accounting as prescribed by GAAP (Generally Accepted Accounting Principle).
- In the accrual system, revenue or expenses are recorded as and when it takes place irrespective of whether cash has been received or not. The total receipt from selling the goods or services is known as gross revenue.
- Net Sales: To arrive at the net sales figure, few items of price adjustments, deductions, and returns need to be separated from the gross revenue. The formula for net sales is as follows:
- Cost of Goods Sold: The direct costs such as raw material and labor for the units of goods sold are considered as COGS(Cost of Goods Sold). Here we do not include indirect costs such as selling and administration expenses.
- The remaining goods whether in the finished or unfished condition is called inventory. So, we take the opening inventory (closing inventory of the previous year), add purchases and other direct expenses, and deduct the closing inventory (stock of unsold products). It is calculated as follows:
Steps to Calculate Gross Margin
The calculation of gross margin equation can be done by using the following steps:
Step 1:Firstly, we would calculate the net sales by deducting returns, discounts and other adjustments in the sales amount.
Step 2:Then, Cost Of Goods Sold (COGS) would be derived by adding all the purchases, direct cost (labor and material), Opening Inventory, and by subtracting Closing Inventory.
Step 3:Now, we could calculate the Gross Margin by reducing COGS from Net Sales.
Step 4:Also, to arrive at the Gross Margin Percentage, we need to divide the Gross Margin (calculated above) from the Net Sales.
Examples of Gross Margin Formula(with Excel Template)
Let’s see some simple to advanced examples of the gross margin equation to understand it better.
Gross Margin Formula Example #1
Let’s take the example of Apple Inc. as on September 28, 2019. The company has sold products and services worth $213,833 million and $46,291 million respectively. The cost of goods sold includes the Cost allocated to products and services amounting to $144,996 million and $16786 million each. Find out the Gross Margin and Gross Margin percentage.
Solution:
Use the below-given data for the calculation of gross margin.
Calculation of Gross margin can be done as follows:
Gross Margin = $260174 – $161782
Gross margin will be –
Gross Margin = $98,392
Calculation of Gross margin % can be done as follows:
Gross Margin (%) = ($260174 – $161782 ) * 100% / $260174
Gross Margin (%) will be –
Gross Margin (%) = 38%
Explanation
The gross margin equation expresses the percentage of gross profit, the company is earning from $1 of sales. In the above case, Apple Inc. has arrived at a gross margin of $ 98,392, and 38% as in percentage form. This 38% of gross margin indicates, that out of 1$ of revenue from the net sales, Apple Inc. is able to make a gross profit of 0.38 cents.
Gross Margin Formula Example #2
Let’s also take one more example. We have data from Microsoft Inc. For the year ended June 30, Microsoft had a Revenue from products and services and another dept. of $ 66,069 million and $59,774 million respectively. Also, In the same period, The Cost of Revenue for Product and Service and another dept. is $16273 million and $26,637 million respectively. We will try to calculate Gross Profit Margin from the above-mentioned data.
Solution:
Use the below-given data for the calculation of gross margin.
Calculation of gross margin in excel can be done as follows:
Gross Margin = $125843 – $42910
Gross Margin will be –
Gross Margin = $ 82,933.
Calculation of gross margin (%) can be done as follows:
Gross Margin (%) = ($125843 – $42910) * 100 % / $125843
Gross Margin (%) will be –
Gross Margin (%) = 66%
Explanation
As we can see, Microsoft has clocked the Gross margin to the tune of $ 82,933 million and 66% in terms of percentage. As Microsoft Inc. and Apple Inc. are in similar fields, we would be able to compare these companies. In the absolute term, Apple Inc. has a Gross Margin of $ 98,392 million whereas Microsoft has earned only $ 82933 million. But, when it comes to the percentage figures, Microsoft Inc. has a superior margin at 66% in comparison to 38% of Apple Inc.
Relevance and Uses of Gross Margin Formula
Gross margin plays an important role in the evaluation of the company for various purposes. Few noted ones are mentioned below:
- It is an important indicator of judging the ability of the entity to clocking profits from its core operations. At this stage, the Gross profit margin only includes the operating revenue and expenses. Hence, the company’s fundamental strength is being observed by this ratio. The higher ratio reflects the robust strength of the company to make profits.
- The main constituents of the Gross Margin Ratio are the operating revenue and expenses. These two heads are vital to the business and help the management to oversee the performance of the production and sales division.
- If the Gross margin ratio is falling, the unproductive department could be easily tracked down, and work upon. Multiple measures could be taken to increase the productivity of that particular department. On the other hand, if the decline in the ratio has been caused by the revenue’s side, problems in the sales and distribution department should be taken into consideration.
- The gross profit ratio is also known as the Contribution from the sales. The contribution from sales helps the business be on track. If we want to accumulate a profit of $500 and we earn a contribution of $5 per unit, we require to sell at least 100 units to meet our target. If there is not enough market for 100 units then either we need to decrease the production cost, or increase the sales price.
- By comparing the Gross Margin ratio of various companies, in the same industry or similar business environments, we could easily assess the superiority or inferiority of the respective company in relation to its peers. So, it turns out to be one of the primary factors to be checked when a better player from the same industry needs to be picked.
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