Understanding gross margin

Definition

Gross margin is the share of each sales dollar still left after the direct cost of the goods or services you sold. On the books, this is a percentage read from the Income Statement, not a cash pile and not a Balance Sheet account.

An olive oil shop that sells a $50 bottle that cost $20 has $30 of leftover and a 60 percent figure here. The $50 is revenue; the $20 is cost of goods sold; this rate is $30 divided by $50.

Cash-basis shops may feel product cost when they pay the mill. Accrual books wait until the bottle sells, and they hold unsold tins as inventory.

This rate is a period result. It is not the shelf stock, and it is not the register balance.

Where it shows up

P&L: Related to how much of each sales dollar is left after direct cost.

Balance Sheet: Related to inventory cost sitting under those sales.

See also: Gross Profit · Cost Of Goods Sold · Revenue

When you look at your Income Statement, you compute this rate from the leftover just below cost of goods sold. Revenue is the denominator; the leftover after product cost is the numerator.

When the rate is high, the shop kept a larger share of each sales dollar after the oil itself. When it is low, the tins were expensive, discounts ate the price, or the mix shifted toward cheaper bottles.

The Balance Sheet does not list this percentage. Related stock still on hand sits in inventory at cost until the next sale.

On the Statement of Cash Flows, collecting from customers and paying the mill are the cash events. This rate does not itself move cash.

How it works

The shop records sales when bottles go out. You then divide the leftover after cost of goods sold by the revenue those sales brought in.

Write the result as a percentage. A $30 leftover on $50 of sales is 60 percent.

Stay with sold bottles when you read this rate. Tins still on the shelf are still inventory, so they do not enter the percentage yet.

A busy holiday week can raise the dollar leftover without changing this rate. The share stays the same if every bottle still cost 40 percent of its price.

Discounts shrink the denominator and the leftover together. A $50 bottle marked down to $40, still costing $20, falls from 60 percent to 50 percent.

Operating expenses such as rent and ads sit below the leftover used in this math. They do not change this rate; they come out later on the way to operating income.

After the close, this percentage is part of the period's profit story. Next month starts the division again from that month's sales and that month's product cost.

Keep the sales recap and the sold-cost support together. Anyone asking why the rate moved should see both the prices and the mill invoices.

Do not treat a high rate as proof the shop is flush with cash. Invoices can still sit open, and a high share of a slow week is still a small dollar leftover.

Freight that belongs on the tins can sit in the unit cost. Those extra dollars leave with the bottle and pull this rate down when the tin sells.

Example

An olive oil shop sells 40 bottles at $50 each on Saturday, for $2,000 of sales. Those bottles cost $20 each, or $800 in total.

The leftover is $1,200. Gross margin is $1,200 divided by $2,000, which is 60 percent.

If $300 of unsold tins is still on the shelf, that $300 stays on the Balance Sheet. It does not enter this weekend's rate.

The shop does not need a separate journal for this percentage. The sales entry and the sold-cost entry already give the two numbers you divide.

If the same weekend also had $200 of discounts, revenue would be $1,800. The leftover would be $1,000, and the rate would fall to about 56 percent.

Common mix-ups

Gross margin is not the same as gross profit. Gross profit is the dollar leftover; this figure is that leftover as a share of revenue.

Gross margin is not markup. Markup is the amount added to cost to set a price, often read as a share of cost, not of sales.

Gross margin is not operating margin. Operating margin waits until rent, wages, and ads have come out.

Related terms

• Gross Profit: Revenue minus the direct cost of delivering it.
• Revenue: The total value of goods and services the business earned in a period.
• Cost Of Goods Sold: The direct cost of the products sold during the period.
• Contribution Margin: Revenue minus variable costs, showing what is left to cover fixed costs.
• Operating Margin: Operating income as a percentage of revenue.
• Pricing: The set price charged to customers for a product or service.
• Income Statement: A statement showing revenue earned and expenses incurred over a period, ending in net income.
• Markup: The amount added to cost to set a selling price.