'Gross Margin' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Gross Margin is also known as gross profit margin. This concept represents a business formula that companies compute. It is best expressed as the firm’s total revenue less its cots of goods sold which is then divided by the total revenue. This provides the answer as a percentage. In other words, Gross Margins are the percentage of revenues the corporations keep after paying their direct expenses of creating both their services and goods. Higher percentages mean a company keeps a larger amount of every dollar worth of sales. This greater amount of retained income provides it with more money for servicing debt, making new investments, retained earnings, and paying out dividends to shareholders.
Gross margin equates to the amount from every sales dollar that the firm is able to keep for their gross profits. Consider a concrete and tangible real world example to better understand this idea. If HSBC Bank has a gross margin in a quarter of 30 percent, then this means it keeps 30 cents from every dollar in revenue it creates. The other 70 cents would go into the Cost of Goods Sold (COGS) category. Since all of the bank’s COGS are already considered, the other 30 cents per dollar in revenue may be applied to general overhead, paying down any debt, expenses on interest, and shareholder dividend distributions.
Corporations utilize this gross margin in order to ascertain how their costs of production are measuring up against their revenues. When a corporation’s gross margin is declining, it will try to find ways to reduce its costs of suppliers and labor costs. The supplier costs can be slashed by finding alternative suppliers who will supply the goods at lower prices. The other solution is to try to raise the prices on the company goods and services so as to increase the value of the corporate sales revenues.
Another effective use of gross margins lies in predicting the amount of money which they will retain towards general operating costs. Companies with 45 percent gross margins know they will have to work with 45 cents on each dollar of revenue they collect in order cover their remaining administrative and operating costs. The measure also allows for firms to measure up their efficiency as a company. Investors and analysts are able to compare and contrast two or more corporations of varying sizes against one another with the metric as well.
Gross margin should never be erroneously confused with net profit margin. Gross margin simply considers the connection between the cost of goods sold and the sales revenue. On the other hand, net profit margin covers every expense a corporation has. Calculating up the net profit margins requires firms to start with their revenues and subtract out their cost of goods sold and other expenses. This includes sales rep wages, distribution of product costs, taxes, and various operating costs.
Another way of looking at the differences between the two related but still different concepts is that the gross profit margin allows firms to determine the level of their manufacturing operations’ profitability. Alternatively the net profit margin assists firms in considering their level of all around profitability.
Consider another example for calculating up gross profit margin. If a company brings in two million dollars in sales revenue, it might spend $800,000 on its labor expenses and another $200,000 on the manufacturing inputs. Once these costs of goods sold of one million dollars are subtracted out, a full million dollars remains in total gross profits. When individuals take the gross profits and divide it by the total revenue, the result is 0.5. Turned into a percentage, this equals a gross profit margin of 50 percent.