How it is calculated
Gross profit = revenue - cost of goods sold
Gross margin % = gross profit / revenue × 100
Cost of goods sold (also called cost of sales) is the direct cost of what was sold: materials, purchased stock, direct labour and subcontractors. Rent, admin salaries and marketing are overhead and sit below gross profit.
Worked example
| September | October | |
|---|---|---|
| Revenue | $200,000 | $220,000 |
| Cost of goods sold | $130,000 | $149,600 |
| Gross profit | $70,000 | $70,400 |
| Gross margin | 35.0% | 32.0% |
Sales grew $20,000 but gross profit grew only $400, because margin fell 3 percentage points. On October's sales, that 3-point drop cost $6,600 of gross profit ($220,000 × 3%). That is the number to explain: a price change, a costly job or a change in product mix.
Common mistakes
- Confusing margin with markup. September's markup on cost is $70,000 / $130,000 = 53.8%. Its margin is 35%. Pricing on "35% markup" when you need a 35% margin loses money.
- Inconsistent COGS. If direct labour is in COGS some months and overhead in others, margin jumps for no real reason.
- Skipping inventory adjustments. Without a month-end stock count or adjustment, COGS and margin swing with purchase timing.
- Comparing across industries. A software company and a distributor have very different normal margins.
Related terms
- Percentage points vs percent: A percentage point is the simple difference between two percentages, while a percent change is that difference relative to the starting value.
- Variance analysis: Variance analysis is the process of comparing actual results with a budget, forecast or prior period, measuring the difference and explaining why it happened.
- Accrual vs cash basis: Accrual basis accounting records revenue when it is earned and expenses when they are incurred, whatever the date cash moves.
Further reading
- How to review a client's P&L every month
- Monthly Review: the nvisin tool built around this