What it is:
How it works (Example):
Why it Matters:
Gross margin is important because it reflects the core profitability of a company before overhead costs, and it illustrates the financial success of a product or service.
Gross margin is used to calculate gross profit margin, which is calculated by simply dividing gross margin by total revenue (gross margin / total revenue). Calculating gross profit margin allows you to compare similar companies to each other and to the industry as a whole to determine relative profitability.
Companies with higher gross profit margins have a competitive edge over rivals, whether because they can charge a higher price for good/services (as reflected in higher revenues) or because they pay less for direct costs (as reflected in lower costs of goods sold).
Analysts are constantly asking themselves, "Why can some industries maintain profit margins that are so much higher than others?" The answer lies with Porter's Five Forces, a classic business framework for discovering which firms will outperform the competition. To learn more, click here to learn about Using Porter's Five Forces to Lock In Long-Term Profits.