The financial ratio known as gross margin is a measure of a company’s ability to profitably make a product or supply a service. This measure only requires two inputs found on the income statement: revenues and the cost of goods sold.
Gross Margin = Gross Profits / Revenues
- Gross Profits = Revenues – Cost of Goods Sold
The closer the gross profit margin is to 1.0, the more efficient the operation. This is true because as the gross profit margin approaches 1.0, the cost of goods sold approaches zero. Relatively high gross margins may be an indicator of brand loyalty or a trade / manufacturing advantage.
When making benchmark comparisons, investors and analysts look for companies with relatively high gross margins. When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.
Company A’s balance sheet indicates revenues of $29,611,000 and a cost of revenue (another name for cost of goods sold) of $15,693,000. Company A’s gross margin would be:
= ($29,611,000 – $15,693,000) / $29,611,000 = $13,918,000/ $29,611,000, or 0.47