How to Calculate Gross Margin

When running a small business, several key financial metrics can give you important insight into how efficient that business is and how well it’s performing. Gross profit, net profit and working capital are high on the list, but gross margin certainly shouldn’t be overlooked.

What Is Gross Margin? 

Gross margin, also known as gross profit margin, will highlight how efficiently a business operates and how profitably it can sell its products or services. It shows the profit made after accounting for the cost of producing goods and services, also known as the cost of goods sold (COGS).

The aim is to have a stable or growing gross profit margin, although it may decline if, for example, you invest in your operations.

How to Calculate Gross Margin

Gross margin is gross profit divided by revenue, times 100.

As an example, let’s say your business makes £50,000, but it costs you £18,000 to provide your services. Your gross profit would be £32,000, making your gross margin 64%. 

What Is the Difference Between Gross Profit and Gross Margin? 

While gross profit and gross margin may sound similar, both measure profitability using revenue and cost of goods sold; the critical difference is that gross profit is a numerical amount, whereas gross margin is a ratio.

Gross profit is the income left over after subtracting the cost of producing and selling a business’ products from its total sales revenue. Unlike gross margin, though, it doesn’t offer insight into how efficiently you deliver those goods and services.

Gross margin is a percentage that also makes it a helpful metric for business owners to compare their margin against the industry standard or competitors. 

While the two combined will help you measure the profitability of the business, they should not be used interchangeably.

We go into more detail into Gross Profit in this guide.

What Does the Gross Margin Tell You?

As with most financial metrics, it’s essential to consider your gross margin alongside other data and record it over the long term to identify trends. A high gross margin across several years means your business is generating profitability from efficiencies in labour and production processes. If your gross margin starts to decline, it is a sign that you need to look at these costs and see if there is a reason for them increasing that can be mitigated, such as by sourcing new suppliers.

A gross margin that fluctuates could indicate a problem with the product, its production, or even management issues within the company.

Gross margin can also be helpful if you’re considering launching new products or services. Any new spending on staff or manufacturing associated with this launch will affect your margins, so tracking these changes will give you some insight into whether the new offerings are viable or not.

It’s also worth noting that while monitoring gross margins will allow you to understand your business’ profitability, it does not account for critical financial considerations such as administration and personnel costs. These would be included in the operating margin calculation. Again, this means making decisions to cut costs, alter processes or take other steps to improve your gross margin should not be taken in isolation.

What is a Good Gross Margin? 

As mentioned, the key is to aim for a stable gross profit margin, but what this should be will vary depending on several factors. Whereas retailers tend to have gross profit margins in the 20-30% range, service-oriented businesses will likely be much higher as they do not have the costs associated with manufacturing a product. Software developers tend to be among those with the highest gross margins, while transportation and logistics companies are often at the other end of the scale. Gross margin will also likely be lower for start-ups as it takes time to develop efficiencies and learn from what the metrics tell you.