Gross margin
What is Gross margin?
Gross margin is gross profit divided by revenue, showing the percentage of sales remaining after costs classified as cost of revenue.
How it is calculated
Subtract cost of revenue from revenue to obtain gross profit, then divide by revenue. If revenue is $400 million and cost of revenue is $260 million, gross margin is 35%. Use the same reporting scope, currency, and period. Do not compare a reported margin with an adjusted version unless every exclusion is understood and reconciled.
What drives it
Selling prices, product and customer mix, raw materials, labor, freight, hosting, royalties, inventory charges, utilization, and supplier terms can change gross margin. A shift toward higher-margin products can raise the consolidated figure even if no individual product improves. Analysts separate transactional currency effects from translation and identify whether temporary shortages or capacity conditions are likely to persist.
Example
A hardware company raises prices 5%, but component costs rise 8% and sales mix shifts toward entry models. Revenue grows while gross margin falls from 30% to 27%. Gross profit can still increase in dollars. The result should be evaluated with demand elasticity, inventory, operating expenses, and market share rather than interpreted from the percentage alone.
How to interpret it
Stable or rising gross margin can indicate pricing power, favorable mix, procurement gains, or scale. Falling margin can reflect investment in adoption, competition, inflation, or weak utilization. Compare segments and peers only after checking classification. Software firms may classify support or hosting differently, while retailers can present vendor allowances and delivery expenses in different lines.
Limitations and distortions
Gross margin excludes operating expenses and capital needs, so it cannot measure total profitability or cash generation. Cost capitalization and inventory methods affect timing. Gross versus net revenue accounting can transform the ratio without changing transaction economics. Acquisitions, purchase-accounting inventory charges, discontinued operations, and reclassifications can break historical consistency unless the data series is carefully conformed.
Practical checklist
Read the revenue and cost policies, reproduce the calculation, and document reclassifications. Examine price, volume, mix, currency, inventory, utilization, and supplier changes. Compare both margin and gross-profit dollars. Connect gross margin to operating margin and free cash flow, and test whether improvement required unusual discounts, lower service, deferred maintenance, or other actions that could weaken future economics.
Also known as: gross profit margin
Sources and further reading
- Introduction to Financial Statement Analysis, CFA Institute
- How to Read a 10-K, Investor.gov, U.S. Securities and Exchange Commission