Understanding Gross Margin: Definition and Key Components

This is the first of several articles regarding gross margins to help you better understand why it should be a key metric in your operational decision making.  Gross margin is one of three key profitability metrics that also include Operating Margin and Return on Sales, each meant to delineate the efficiency of different operational segments of nearly every business. 

Gross margin is computed by dividing gross profit, which is Revenue less Cost of Goods (COGS) divided by Revenue.  The formula is as follows:

                            (Revenue – Cost of Goods) / Revenue = Gross Margin %

As you can probably surmise, it represents a difference between a company’s revenue from sales and the cost of goods sold (COGS). This means, gross margin is measuring the efficiency with which a business produces/delivers its goods and services.  Typically, there is a very tight correlation between Revenue and COGS, so much so that there should be a large gross margin variability from one accounting period to the next.  This means that as Revenue volume changes, COGS should closely mirror those same changes.  If COGS doesn’t closely mirror Revenue, then you may want to question whether some of the items classified as COGS really pertain to delivering Revenue. 

You may be wondering what constitutes a “good” gross margin.  Well, that depends on the business model.  Walmart has built a fairly successful business on 25% gross margins.  Pfizer, another successful company, has gross margins closer to 75%.  Both businesses generate a Return on Equity in the mid to high teens.  So the answer to the question regarding what’s a good Gross Margin depends on the business model.  But a good place to start is to look at other companies in your industry and look at their gross margins, which is a form of benchmarking.  Your homework before our next Gross Margin article is to go out and find a good company to benchmark your gross margins.  If you’re at a loss as to where to look, a good place is to look at public company filings at the SEC’s filing database located at: https://www.sec.gov/search-filings.