Gross margin is a method that investors can use to determine a company’s operating efficiency. Gross margin is the profit that a company keeps from every dollar of revenue. Gross margin is represented as a percentage. The formula for it is:
Gross Margin = Net Sales − COGS
Where net sales are the same as revenue and COGS is the cost of goods sold. Basically, gross margin is the profit remaining after removing direct costs (COGS). Direct costs are those costs that are directly related to creating the product. Salaries and administrative overhead are not direct costs.
When investors use gross margin, they want to compare gross margin across companies to determine which companies are performing the best. Gross margin should only be compared against similar companies or those within the same industry. Each industry has an average gross margin. Investors can compare a company to the industry’s average as a baseline (i.e., is the company doing better or worse than the industry average). Then they can compare to the top-performing companies within the industry. These comparisons provide investors with great insight into the company’s operating efficiency and where it stands against its top competitors.
As an example, assume a company makes $500,000 per year on one product line. It spends $200,000 on supplies and $100,000 on labor to create its products. That’s a total COGS of $300,000. The gross margin for this product line is $500,000 - $300,000 = $200,000 then $200,000/$500,000 = 40%. The company’s gross margin is 40%. If the industry average gross margin is 35%, the company is performing better than half of its peers.
Note that gross margin does not equal profits. Selling/general/administrative costs and taxes still need to be deducted from gross margin to find the profit value.