Gross margin: Definition, formula + how to improve it for 2025

For instance, imagine a small retail store that purchases inventory from multiple suppliers. By negotiating better deals with suppliers, it can reduce its COGS, increasing gross margin without affecting product quality. Additionally, reducing marketing and advertising expenses without compromising product or service quality could help businesses save money. By analyzing trends in sales volume, pricing strategies or cost-reduction initiatives can be implemented to maximize profits while maintaining high levels of customer satisfaction. For example, if a company with $100,000 in revenue has a gross margin of 50%, it means they have $50,000 left over after accounting for the COGS. The concept of GP is particularly important to cost accountants and management because it allows them to create budgets and forecast future activities.

Ask Any Financial Question

You can also use your gross margin percentage to compare your profits to those of similar businesses in your industry. Since they likely have a similar cost of goods sold, you can use this metric to compare your total sales revenue. The terms gross margin and gross profit are often used interchangeably but they're two separate metrics that companies use to measure and express their profitability.

Gross Margin Formula

Once you've found the average gross margin in your field, you should attempt to meet or exceed the average. The global nature of today's business landscape means that companies often face competition from local entities and foreign companies with potentially lower operational costs. Analyzing customer demand and behavior can also gross margin accounting help you identify areas for improvement in your product line or marketing strategy. Another way to increase sales is through promotional campaigns such as discounts or special offers that can incentivize buying behavior. Another way to reduce costs is by negotiating better deals with suppliers for raw materials or inventory.

• Gross profit and gross profit margin may sound like the same term but they are a little different.
• Companies might need to reduce prices to clear out inventory or to stay relevant, impacting the gross margin.
• Total revenue is the final amount of your net sales for a given period.
• Our intuitive software automates the busywork with powerful tools and features designed to help you simplify your financial management and make informed business decisions.
• Companies may adopt various pricing strategies, such as cost-plus, value-based, or competitive pricing, each of which can have different implications for the gross margin.
• Additionally, knowing the factors that impact gross margin allows companies to adjust their operations strategically.

How Gross Profit Margin Works

In other words, gross margin reflects the efficiency of a company in producing its goods or services. The higher the percentage, the better the company is at retaining capital. Every successful business keeps its costs below revenue to generate profits. The gross margin of individual products could indicate to management that some products should be promoted more aggressively and some products should be phased out. Both the total sales and cost of goods sold are found on the income statement. Occasionally, COGS is broken down into smaller categories of costs like materials and labor.

For instance, they could measure the profits if 100,000 units were sold or 500,000 units were sold by multiplying the potential number of units sold by the sales price and the GP margin. The gross profit margin (also known as gross profit rate, or gross profit ratio) is a profitability metric that shows the percentage of gross profit of total sales. A higher gross profit margin indicates a more profitable and efficient company. However, comparing companies' margins within the same industry is essential, as this allows for a fair assessment due to similar operational variables. To calculate a company’s net profit margin, subtract the COGS, operating expenses, other expenses, interest, and taxes from its revenue.

Shorten your sales cycle

Gross profit margins can also be used to measure company efficiency or compare two companies with different market capitalizations. Gross margin ratio is calculated by dividing gross margin by net sales. Every business owner should analyze key financial ratios to improve business results.

Gross profit margin is the profit a company makes expressed as a percentage. Fluctuations in currency values, changes in import-export regulations, or even global supply chain disruptions can influence both revenue and COGS, thereby affecting the gross margin. On the other hand, a penetration pricing strategy, where prices are set lower to capture market share, might result in slimmer margins, at least in the short term. However, it's worth noting that a high gross margin doesn't always translate to net profitability. Compare your prices against competitors and calculate whether you can match or compete.

High-margin items typically have higher risks or require more marketing efforts, while low-margin items might rely on high sales volumes. Any other operating expense or indirect costs such as taxes, rent, insurance, and professional services. Gross margin includes an allocation of factory overhead costs, some of which may be fixed costs or mixed costs. Because of the overhead cost inclusion, gross margin is not the same as contribution margin (which only reduces sales by the amount of any variable expenses incurred).

You might have to change only one or more aspects to witness the desired results in your margin. Streamlining processes is one of the most efficient ways to improve gross margin. By analyzing and optimizing workflows, businesses can reduce wastage and improve operational efficiency, which leads to cost savings. The cost and quality of raw materials can significantly impact the gross margin. Any fluctuation in these costs—whether due to supply chain disruptions, geopolitical events, or other reasons—can have a direct effect on gross profit. For instance, let's consider Apple Inc., one of the world's most profitable companies.