The difference between revenue and cost in gross margin, simply explained, is that revenue is what is earned, and cost is what is spent. Companies commonly use gross margin to examine only their basic production costs.
Gross margin is the total revenue generated by a company’s sales minus the cost of goods (COGS) directly required for production, which is then divided by the overall sales revenue. The result is given in the form of a percentage. The calculation for gross margin is expressed by the following equation:
Gross margin (%) = Revenue – Cost of Goods Sold / Revenue
Gross margin is expressed in percentage form, and gross profit is expressed as an absolute dollar amount.
Gross margin is only one measurement of profitability for a company, as it includes only part of the company’s costs of doing business: those directly related to production. To further refine the measure of profitability, a company generally next deducts all of its common overhead and operating expenses. These expenses include wages, various administrative costs, cost of facilities, and all marketing or advertising costs. The figure arrived at after subtracting these additional costs is referred to as the operating margin. It is also frequently designated by the phrase “earnings before interest and taxes, or EBIT.” The final profitability calculation, which shows a company’s actual net profits or net profit margin, subtracts interest, taxes, gains or losses from investments, and any other extraneous costs that the company may have incurred that were not included in the calculations for gross margin or operating margin.