In plain English
Compare it across periods and to your industry. A drop signals cost or pricing problems.
It excludes overhead.
Why it matters
Gross margin shows how much of each sales dollar is left to pay overhead after direct costs. If it slips, every extra sale contributes less, and growth can actually make things worse. It is often the earliest sign that supplier prices rose or that discounts are too generous.
It is only as reliable as the split between cost of goods sold and other expenses, so consistent coding matters.
Worked example
Gross profit of $80,000 on revenue of $200,000 is a 40% gross margin ($80,000 / $200,000). If next quarter the margin falls to 35%, find out whether costs rose or prices slipped.
How to handle it
- Confirm that direct costs, such as materials, freight in and job labor, go to cost of goods sold accounts.
- Run a profit and loss and divide gross profit by revenue for each month.
- Track the percentage over time in a spreadsheet rather than looking at a single month.
- If your software supports classes, products or jobs, run the margin by each to see which ones pull the average down.
Common mistakes
- Putting direct costs in overhead, which makes gross margin look better than it really is.
- Confusing margin with markup when setting prices, which leads to pricing lower than intended.
- Comparing months where inventory was not counted or adjusted, which makes the margin swing for no real reason.
Not the same as: Gross profit
Gross profit is a dollar amount, revenue minus cost of goods sold. Gross margin expresses that same amount as a percentage of revenue so it can be compared across periods of different size. See Gross profit.
Go deeper
- Financial Ratios Small Business Owners Should Know: Learn the handful of financial ratios that matter for small businesses: margins, current ratio, debt, collection days, and how to read them.
Try it
Related terms
- Gross profit: Revenue minus cost of goods sold, before operating expenses.
- Income statement (profit and loss): A report of revenue and expenses over a period that shows net profit or loss.
- General ledger: The complete record of every account and transaction in a business's books.
Common questions
What is gross margin?
Gross profit as a percentage of revenue.
Can you give an example of gross margin?
Gross profit of $80,000 on revenue of $200,000 is a 40% gross margin ($80,000 / $200,000). If next quarter the margin falls to 35%, find out whether costs rose or prices slipped.
What is the difference between margin and markup?
Markup is profit as a percentage of cost, while margin is profit as a percentage of the selling price. The same item has a higher markup percentage than margin percentage.
Why did my gross margin drop when my prices did not change?
Common reasons are higher supplier costs, more discounts, a shift toward lower margin products, or inventory adjustments posted to cost of goods sold.
General information, not tax, legal or accounting advice. Confirm rules with the IRS, the NJ Division of Taxation or a licensed professional.