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A gross margin is the difference between the price and cost of a sale expressed as a percentage of the price. This is essentially the portion of the price that is profit before overhead expenses. The following are illustrative examples of a gross margin.
Unit MarginUnit margin is the gross profit portion of a price expressed as a dollar amount. For example, an electronics accessory that is sold for $10 with a unit cost of $6 has the following unit margin.| Unit Margin | = price - unit cost | | = $10 - $6 | | = $4 |
Gross margin is the unit margin expressed as a percentage of price. For example, a table that is sold for $700 that cost $550 to construct, sell and deliver has the following gross margin.| Gross Margin | = ((price - unit cost) / price) × 100 | | = (($700 - $550) / 700) × 100 | | = 21.4% |
Total Gross MarginGross margin is often calculated for all sales achieved by a firm, sales team or salesperson. For example, a firm with revenue of $55 million and cost of goods sold of $17 million has the following total gross margin.| Gross Margin | = ((revenue - cost of goods sold) / revenue) × 100 | | = (($55 million - $17 million) / $55 million) × 100 | | = 69% |
Unit costs change as you scale up and down. As an extreme example, if an assembly line produces one refrigerator, that refrigerator can be viewed as costing tens of millions of dollars as the entire price of the assembly line can be included in its unit cost. As a firm sells more refrigerators, unit costs fall until the assembly line reaches capacity. Contribution margin is a way of modeling the profitability of different production levels based on variable unit costs. This is used to make production decisions. For example, a refrigerator factory that is producing 10,000 units a month has a variable cost for one more unit of $300 with a sales price of $1200. At this point the contribution margin is calculated as follows.| Contribution Margin | = ((revenue - variable unit cost) / revenue) × 100 | | = (($1200 - $300) / $1200) × 100) | | = 75% |
If the factory is producing 20,000 units a month the unit cost jumps to $1100 as the firm needs to contract out assembly and transport the units from another country with tariffs at the border. At this point the contribution margin is as follows.| Contribution Margin | = ((revenue - variable unit cost) / revenue) × 100 | | = (($1200 - $1100) / $1200) * 100) | | = 8.3% |
Reverse Calculation for PricingIt is common to start with a target gross margin and a cost to calculate a price. For example, a home builder sets its initial price at a 40% gross margin and allows the price to be negotiated down depending on market conditions. A particular house cost $240,000 to build such that a price with a 40% margin can be calculated as follows.| Price | = cost + (cost × gross margin) | | = $240,000 + ($240,000 × 0.40) | | = $336,000 |
NotesUnit cost includes any cost can can be attributed to the sale of a unit of a product or service including manufacturing, distribution, service delivery and marketing costs.Cost of goods sold is the aggregate of all unit costs that may be calculated at the level of a firm. Cost of goods sold is carefully matched to its corresponding revenue. |
Type | | Definition | The gross profit of revenue expressed as a percentage of revenue. | Related Concepts | |
Financial Metrics
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