Formula for Gross Margin
In the previous two small business financial management lessons, we’ve calculated the total sales and the cost of goods sold per month at the Fish Shack. The next line that is usually found on the income statement is the gross margin. In this section, we’ll continue the previous lessons by using the formula for gross margin to calculate the next line of the income statement for the Fish Shack.
Income Statement For the Fish Shack
Shown to the right is the generic income statement that walks through how each line is calculated. Since we already found that the Fish Shacks total sales were $36,750 per month and the cost of goods sold was $19,117.50 for the month, we can now put those in our income statement. Now to calculate gross margin, all we need to do is subtract the cost of goods sold from the total sales using the formula for gross margin:
Gross Margin for Month = Sales per Month – Cost of Goods Sold per Month
Gross Margin for Month = $36,750 – $19,117.50 = $17,632.50
Gross margin is the essentially all the money that is left over from the total sales once all the costs of goods sold are paid to make or buy the product. The money that is left over can be used to pay general company expenses (which we’ll talk about next) and taxes. Any money that is left is profit for the company!
Gross Margin Ratio as a Percentage of Total Sales
One thing that you may commonly see is gross margin listed as a percentage. When people talk about a gross margin ratio (listing it as a percentage), really what they are saying is gross margin as a percentage of sales. Let’s calculate what the gross margin percentage is for the fish shack:
Gross Margin Ratio = Gross Margin / Total Sales = $17,632.50 / $36,750 = 48%
What this number means is that for every $1 that you sell, 48% of that dollar (or $0.48) is left after the company paid for all of the costs of goods sold to make or buy the product. It can be valuable to calculate this value as a percentage when looking at how one company is doing compared to another. Since total sales could be very different, comparing the gross margin probably won’t be as valuable as knowing the percentage of what the other company is left over for every $1 of total sales.
To improve the gross margin ratio percentage, you can either increase the amount you are able to charge for each item sold or decrease how much it costs to produce the product (the cost of goods sold). After we go through the financial statements, we’ll discuss other ratios that are useful when comparing companies against each other.
Key Takeaway: The formula for gross margin of a company is calculated by subtracting the cost of good sales from the total sales over the same period of time.
The Five Minute Gross Margin Rundown