Gross margin, sometimes referred to as gross profit margin, is the amount of profit realized after the subtraction of cost of goods sold. Gross margin percentages differ between industries. For example, the cost of building a car is much greater than the cost of developing software. Therefore, gross profit percentages in the car manufacturing industry are much lower than margins earned by companies such as Microsoft.
Calculating Gross Margin
A company's gross margin displays as a percentage. Accountants arrive at this percentage by taking sales revenue and subtracting the cost of the product that was sold. Thus, the accountant divides the number by revenue, which gives him a gross margin percentage. For example, if a person can buy a pair of shoes for $15 and sell them for $50, he subtracts the $15 cost from $50 and divides it by the $50 revenue he earned. This gives him a gross margin of 70 percent.
Industries that sell goods and services that have relatively low costs have higher gross margin percentages than those with higher costs. Service industries have the highest gross margin percentages. For example, law firms, health care and banking all have gross margins above 90 percent, according to Butler Consultants. Meanwhile, many retail industries, such as car dealers, food stores and gas stations have gross margins below 30 percent.
Good Gross Margins
Gross margins are relative. For example, Oracle has a gross margin of 79.51 percent, while the software development industry standard is 76.8 percent. Thus, it would be fair to say Microsoft has a good gross margin percentage because it outpaces the industry standard. Likewise, a car dealer that has a gross margin of 15 percent has a healthy margin because this is higher than the industry standard, which is below 5.9 percent.
Gross margin percentages change over time as the cost of goods sold and the price companies can sell their products for change. It is a good idea for investors to avoid investing in companies that have declining gross margin percentages. In order to determine if margin percentages are declining, investors should compare margins over the past five years to see if a declining trend exists.