The margin cost or direct cost margin is determined by subtracting the total of all the direct costs related to the production of goods from the generated revenue through the sale of goods or services, divided by the total revenue.
The direct cost margin, measured as a percentage, shows what portion of each sale is profit after accounting for expenses resulting from production and operational costs.
The direct cost margin is often called the gross margin and is an essential metric in corporate finance. Learn more about margin cost or gross margin, and how to calculate it next.
Direct costs are those expenditures that can be necessarily tied to selling products. In manufacturing, these include raw materials such as wood, paint, hardware, and labor costs required to create each product.
For retail activities, direct costs include the price paid to the wholesaler or supplier and any payments made to sales representatives. Depending on the process, supervisory compensation can also be included if the supervisor’s role is specifically and exceptionally advantageous to the production or selling of products.
Employee compensation or wages whose duties are not directly related to the production or selling of goods are not counted as direct costs.
Often direct costs are used interchangeably with the cost of goods sold (COGS). Some other direct costs may include the following.
- Direct labor
- Direct materials
- Manufacturing supplies
- Wages for the production staff
- Fuel or power consumption
How to Calculate Margin Cost
Margin cost or gross margin is the net sales revenue of a business, minus its COGS. In other words, it is the sales revenue that a business holds after deducting the direct expenses involved with manufacturing the products it sells and the services it offers.
This margin can be represented in two ways, depending on how sales and expense data are labeled on company financial statements. See below for formulas.
Direct Cost Margin = (Revenue – Direct Costs) / Revenue
Gross Margin = (Revenue – Cost of goods sold) / Revenue
The higher the gross margin, the more capital a business holds on each money of sales, which can then be used to cover certain expenses or meet debt obligations. The net sales figure is actually gross income, minus the returns, allowances, and rebates.
To give an example of a gross margin calculation, suppose a business gathered $300,000 in revenue from sales. Let’s assume that the cost of the goods is the $30,000 it spends on supplies for manufacturing, plus the $90,000 it pays in labor costs. The business thus enjoys a gross margin of $180,000 after subtracting its COGS.
Understanding Gross Margin
The gross margin refers to the portion of every income the business retains as gross profit. For example, if the recent quarterly gross margin of a company is 55 percent, it keeps $0.55 from each generated dollar of revenue.
Since COGS has already been taken into account, the remaining funds can then be channeled into paying the loans, general and administrative costs, interest payments, and dividend distributions to shareholders.
Companies use the gross margin to gauge how their revenues relate to their production costs. For example, if a business’s gross margin drops, it may seek to cut down labor costs or bring in cheaper materials suppliers.
Optionally, as a way to increase revenue, it can decide to increase pricing. Gross profit margins may also be used to calculate companies’ efficiency or equate two companies within distinct markets.
Gross Margin vs. Net Margin
Although the gross margin is based solely on the relationship between revenue and COGS, the net profit margin takes into account all the expenses of a company.
Companies subtract their COGS when calculating net profit margins and ancillary expenses, including product distribution, salesperson salaries, miscellaneous operational costs, and taxes.
Gross margin (also called gross profit margin) helps a business determine its manufacturing operations productivity. In contrast, the net profit margin lets the company evaluate its overall profitability.
Gross margin or margin cost is a significant factor to consider when assessing a business’s productivity and financial performance. This is a critical indicator as it demonstrates the management’s flexibility in using labor and resources in the manufacturing cycle.