What gross profit margin tells you
Revenue here means net sales: what customers were charged, less returns, allowances and discounts. Gross profit is what is left of that revenue after cost of goods sold, the direct cost of the goods or services that were sold. For a reseller that is mainly the purchase cost of the goods. For a manufacturer it also includes materials, direct labor and production overheads.
A result of 40% means that 40% of revenue remains after the direct cost of sales, and the other 60% went on the cost of what was sold. That 40% has to pay for operating expenses such as rent, salaries and marketing. Whatever is left after those becomes operating profit.
Two ways to calculate it
The calculator offers two methods that give the same result. Use From gross profit if your income statement already shows a gross profit line. Use From revenue and cost of goods sold if it shows only those two figures, and the calculator works out gross profit for you. The term “gross margin” can mean either the amount of gross profit or this percentage, so make clear which one you mean when you share figures.
Reading a high or low result
Gross margins vary widely between industries, because businesses differ in how much of their cost sits in the product itself and how much sits in overheads. A business with low production costs and heavy spending on development or marketing can show a high gross margin and still make a loss. Compare the margin with earlier periods of the same business, or with similar businesses.
- A rising margin can come from higher prices, cheaper materials or purchases, or a shift in sales toward higher-margin products.
- A falling margin can mean costs rose faster than prices, discounting increased, or the sales mix moved toward lower-margin lines. It can also reflect one-off charges in cost of goods sold, such as writing down inventory that will not sell at full price.
- A negative margin means cost of goods sold was higher than revenue, so the business lost money on what it sold before paying any overheads.
What the margin does not show
- It stops before operating expenses, so a high gross margin says nothing about whether the business covers its overheads.
- Businesses draw the line between cost of goods sold and operating expenses in different places. Shipping, warehousing or the depreciation of production equipment may sit in either, which affects comparisons.
- It is a percentage, not an amount. A lower margin on much higher sales can still produce more gross profit.
Common mistakes
- Using gross sales before returns, allowances and discounts. Base the margin on net sales.
- Confusing margin with markup. Markup divides gross profit by cost rather than by revenue, so on a profitable sale the markup is always higher than the margin. See margin vs markup for the difference.
- Comparing businesses without checking which costs each one puts in cost of goods sold.
- Mixing periods, such as revenue for a full year with cost of goods sold for eleven months.
Related measures
Operating profit margin goes one step further and also deducts operating expenses, so the gap between the two margins shows how much of revenue goes on overheads. To see how gross margin relates to the bottom line, read gross vs net profit margin. For pricing a single product rather than analyzing a whole income statement, use the margin calculator.