Gross Margin: the percentage that the Revenue exceeds the direct cost of producing the object or service being sold. It represents the amount of each revenue dollar the company gets to use to cover overhead, fixed costs and to generate a profit. At the most fundamental level, Gross Margin is an indication of how profitable the company is or can be.
As a formula, Gross Margin is equal to Revenues less Cost of Goods Sold (COGS),or Costs of Sales (COS) for a service business typically expressed as a percentage of the Gross Revenues.
Gross Margin is often used to determine pricing for a company’s product or service. The company has to price their products or services relative to their competitors, but the price always has to be higher than the costs to produce the product or service for a company to have any ability to produce a net profit. Companies that pay close attention to Gross Margin will look closely at their COGS or COS to reduce these costs to improve their Gross Margin. For a Product company some important items that will be looked at are material costs, labor costs, and product redesigns to reduce both material costs as well as labor costs. For a Service business some important items that will be looked at are labor costs, material cost consumed in providing the service, and service redesign to reduce both labor and consumable materials.
Often companies that provide a service rather than a product will not record any COGS or COS in their financial records. This results in 100% Gross Margin and it is difficult for these companies to set service pricing to insure profitability. Another common oversight in a service business is not considering labor in COS to provide the service. In a service business labor is usually the highest cost in their Cost of Sales, so not including these labor costs can lead to low pricing causing net profits to be very low. Both hourly and salaried personnel that provide services should allocate their time when they are directly providing a service to a customer. This time and cost would be included in COS and their remaining costs would be considered overhead.
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