Gross Margin Calculator

What Is Gross Profit

Gross profit is the money a company keeps after paying for the direct costs of providing its products or services. It is sometimes referred to as sales profit or gross income. To find gross profit, subtract the cost of goods sold (COGS) or cost of services from total revenue.  

Gross Profit Formula 

Components of Gross Profit

1. Revenue (Sales Income): This is the total amount of money earned from selling goods or services before any expenses are deducted. It includes all sales from customers within a given period, such as monthly, quarterly, or annually.
2. Cost of Goods Sold (COGS): This refers to the direct costs associated with producing the goods or services sold. For manufacturing businesses, this includes raw materials, direct labor, and production costs. For service companies, COGS encompasses billable employee time, subcontractor fees, and project-specific expenses directly tied to client deliverables. COGS do not include overhead costs such as rent or utilities.

What Is Gross Margin 

Gross margin or gross profit percentage or gross ratio is a profitability metric. It indicates the percentage of revenue a company retains after deducting the direct costs of producing goods or services. It’s calculated by subtracting Cost of Goods Sold (COGS) from total revenue. Then, divide that number by total revenue. Gross margin helps you understand the basic profitability of a business before considering other expenses. 

Gross Margin Formula 

Example of Gross Margin Calculation

Now that we’ve covered the fundamentals of gross margin, let’s explore a practical example.

This means that after covering the direct costs of delivering client services, your firm retains 40% of revenue as gross profit before accounting for operating expenses like office rent, non-billable staff time, marketing, and administrative costs.

What Does Gross Margin Tell You 

Gross margin is a key indicator of a company’s financial health. A high gross margin means a company keeps more revenue after covering production costs. This provides more room for operating expenses and profit. Gross margin is essential for:

Pricing Strategy: It helps evaluate if your pricing strategy is working.

Cost Control: It shows how well the company manages production costs.

Investment Decisions: Investors use gross margin to evaluate a company’s profitability.

Performance Benchmarking: It helps compare your profitability to industry standards.

What Is Considered a Good Gross Margin 

Understanding what constitutes a “good” gross margin varies across industries. A margin that is considered healthy in one sector might be below average in another. Therefore, it’s essential to compare your company’s gross margin to industry standards to accurately assess its performance. 

Gross Margin Benchmarks by Industry

To provide context, here are average gross margins for various industries, based on data from NYU Stern School of Business:

* Data from NYU Stern School of Business 

These figures highlight the significant variation in gross margins across different sectors. For instance, software companies typically have higher margins due to lower marginal costs, whereas grocery retailers operate with slimmer margins due to high competition and low pricing flexibility. 

What Is an Adjusted Gross Margin?

Adjusted gross margin is used to determine the actual profitability of a product, service, or business. Unlike gross margin, this calculation subtracts additional costs, such as inventory holding costs for products or project-related overhead for services. The formula for calculating Adjusted Gross Margin is:

Gross Profit = Revenue – Cost of Goods or Services Sold (COGS).

Revenue: This is the total income generated from sales.

Inventory Carrying Costs: These include expenses such as office space, utilities, software licenses, training, and development costs, among others.

The adjusted gross margin gives a clearer picture of true profitability than the basic gross margin does. This helps businesses see how much money they keep after all direct and related costs are covered.

Gross Margin vs. Other Profitability Metrics

Gross margin is only one way to measure profitability; however, it is not the only way. To get a complete picture, it helps to compare it with other key metrics. Operating margin, net margin, contributing margin, etc., each show a different side of your business’s financial health. Examining all of them together provides better insights.

Gross Margin vs. Net Profit Margin

The gross margin represents the percentage of revenue remaining after deducting direct costs, such as materials or labor. Net profit margin goes further, subtracting all expenses, including operating costs, interest, and taxes. While gross margin highlights production efficiency, net margin gives a more complete view of overall profitability.

Gross Margin vs. Contribution Margin

Gross margin subtracts only direct costs tied to goods or services sold. Contribution margin, however, deducts all variable costs, not just those directly linked to production. This helps businesses see how much revenue is available to cover fixed costs and generate profit.

Gross Margin vs. Operating Profit Margin

Gross margin focuses on costs directly tied to production. The operating margin subtracts both direct costs and operating expenses, such as rent, salaries, and utilities. The operating margin indicates the amount of profit remaining after deducting all core business expenses from sales.

Gross Margin vs. EBITDA Margin

Gross margin refers to the profit after deducting direct costs. EBITDA margin (Earnings Before Interest, Taxes, Depreciation, and Amortization) accounts for operating expenses but excludes interest, taxes, and non-cash items. EBITDA margin is often used to compare profitability between companies by removing the impact of financing and accounting decisions.

5 Common Mistakes When Calculating Gross Margin

Even small mistakes in gross margin calculation can skew your view of profitability. This is especially true for service businesses, where costs and revenue can be complex. Recognizing these common pitfalls helps ensure the accuracy of your financial analysis. Here are five mistakes to avoid:

1. Miscalculating Cost of Goods Sold (COGS) or Cost of Services

For product businesses, COGS should include all direct costs, such as raw materials, labor, and manufacturing overhead. In the services industry, this means including direct labor (e.g., billable staff hours), subcontractor fees, and any materials or tools used to deliver the service. Excluding relevant direct costs leads to an inaccurate gross margin.

2. Overlooking Overhead and Indirect Costs

Businesses often mistakenly include indirect costs (like rent, utilities, or administrative salaries) in their COGS or cost of services. Only costs directly tied to delivering the product or service should be included. Including unrelated overhead inflates COGS and understates gross margin.

3. Ignoring Proper Revenue Adjustments

Failing to account for discounts, refunds, returns, or allowances can distort your gross margin. In services, this might mean not adjusting for write-offs, client discounts, or project scope reductions, resulting in an overstated gross margin.

4. Inconsistent Cost Allocation Methods

Using inconsistent or incorrect methods to allocate costs can skew your gross margin. This includes switching between different inventory or project costing methods. For services, this includes not consistently tracking billable versus non-billable hours or failing to allocate shared resources appropriately.

5. Confusing Gross Margin with Gross Profit

Gross profit is the absolute dollar amount (revenue minus direct costs), while gross margin is the percentage of revenue that remains after covering direct expenses. Mixing these two metrics can lead to misinterpretation of your business’s financial health, whether you sell products or services.

6 Things to Consider While Calculating Gross Margin

Calculating gross margin is more than just plugging numbers into a formula. For service businesses, especially those in consulting, it’s essential to look beyond basic revenue and costs. The following factors ensure your margin calculations are accurate and truly reflect your business performance. Here are six key things to keep in mind:

1. Include All Direct Labor Costs

Ensure you account for the full salaries of billable employees, including both base pay and overtime, not just the portion tied to billable hours. Don’t forget to add payroll taxes, bonuses, and benefits directly related to client service staff. Accurately capturing these costs is crucial, as labor is often the most significant expense in consulting and professional services.

2. Accurately Allocate Employee Benefits and Related Costs

Go beyond just wages, including health insurance, retirement contributions, training expenses, and any other employment-related costs for staff involved in service delivery. Failing to allocate these can understate your actual service delivery costs and inflate your gross margin. Proper allocation also helps identify opportunities to optimize benefit structures and improve profitability.

3. Recognize Revenue Properly

Match revenue recognition with the period in which the related services are delivered, not just when payments are received. This is especially important for long-term projects or retainer-based work. Accurate revenue recognition ensures that your gross margin accurately reflects the actual financial performance of each period, supporting better forecasting and informed decision-making.

4. Use Up-to-Date and Complete Data

Always rely on the most current and comprehensive data for both revenue and costs. Outdated or incomplete data can lead to significant errors in your gross margin calculation, masking underlying issues or overstating profitability. Regular data updates also allow for more responsive management and timely course corrections.

5. Track Utilization Rates

Monitor the percentage of employee time that is billable versus non-billable, as low utilization can erode gross margin even if billing rates are high. Tracking utilization helps identify inefficiencies, overstaffing, or training needs. Tools like Keka PSA simplify time tracking by clearly separating billable from non-billable hours. It also enforces timesheet compliance by setting rules for accurate, timely submissions. Improving utilization rates can have a direct, positive impact on your gross margin.

6. Compare Against Industry Benchmarks

Regularly benchmark your gross margin against industry standards for consulting and similar services. This provides valuable context for evaluating your performance and competitiveness. Benchmarking can also reveal areas where you may be lagging behind peers and highlight opportunities for process improvements or pricing adjustments.

How To Improve Your Gross Margin: 6 Actionable Steps for Professional Service Businesses 

A good gross margin indicates that a company is generating substantial profits by keeping production costs low relative to its revenue. This means the business is efficient and has more resources to invest in future growth.  A significant gross margin is essential for long-term success and sustainability. Now, let’s look at six practical ways to improve your gross margin:

1. Track and Optimize Billable Hours

Implement precise time tracking for all staff to ensure every billable hour is captured and accurately linked to client projects. This reduces revenue leakage, helps identify unproductive activities, and supports better resource allocation, ultimately increasing the proportion of billable work and improving overall margins. Implementing project management software like Keka PSA can help reduce the chances of unbilled hours.

2. Control Scope Creep and Manage Projects in Real Time

Closely monitor project budgets and deliverables to prevent unplanned work from eroding profitability. Use real-time budget analysis and clear client agreements to identify and address scope changes as they arise, allowing you to renegotiate terms or adjust fees when necessary.

3. Review Client and Project Profitability Regularly

Analyze which clients and projects generate the highest returns relative to the effort invested. Prioritize high-margin work, renegotiate or discontinue unprofitable contracts, and focus your resources on engagements that align with your financial goals.

4. Standardize and Streamline Service Delivery Processes

Develop repeatable processes, proprietary frameworks, and technology solutions to increase efficiency and reduce variability in service delivery. Streamlined operations lower delivery costs, improve quality, and free up resources for higher-value work.

5. Leverage Technology for Financial Visibility and Automation

Adopt platforms that centralize time tracking, billing, and profitability reporting to gain real-time insights into your firm’s financial performance. Automation reduces administrative overhead, minimizes errors, and enables faster, data-driven decision-making.

6. Focus on Value-Based Pricing and Premium Positioning

Differentiate your services by emphasizing measurable outcomes and business value rather than just hours or deliverables. This approach allows you to command higher fees, attract ideal clients, and consistently achieve higher gross margins.