What Is Gross Margin?
Gross margin measures the percentage of revenue a company keeps after paying the direct costs of what it sells, known as cost of goods sold (COGS). The formula is Gross Margin = (Revenue - COGS) / Revenue, or equivalently Gross Profit / Revenue.
It is the first and most fundamental profitability margin on the income statement, capturing the core economics of the product itself before overhead, marketing, and other operating costs enter the picture.
How It Works
COGS includes costs directly tied to production, such as raw materials, direct labor, and manufacturing overhead for a goods company, or hosting and support costs for a software company. Everything else, like sales, R&D, and administrative expenses, sits below gross profit.
Gross margins vary enormously by business model: software companies often run at 70 to 90 percent, branded consumer goods at 40 to 60 percent, and grocery retailers at 20 to 30 percent. That is why margins are most meaningful when compared against a company's own history and its direct peers.
Example
Suppose a company generates $50 million of revenue and incurs $30 million of COGS. Gross profit is $20 million, and gross margin is $20 million / $50 million = 40%. If next year revenue grows to $60 million but COGS rises to $39 million, gross margin slips to 35%, signaling rising input costs or pricing pressure.
Why It Matters
Gross margin is a direct read on pricing power and cost control: expanding margins suggest a strengthening competitive position, while eroding margins often flag commoditization. Investors also use it to judge how much room a company has to fund growth spending below the gross profit line.
In interviews and on the job, walking down the income statement from revenue through gross, operating, and net margins is one of the most common analytical exercises in finance.
