Does Gross Margin Include Overhead Costs?
Understand how separating production costs from overhead provides a clearer view of a company's financial efficiency and overall profitability.
Financial metrics are foundational tools for assessing a business’s performance and stability. Among the most frequently discussed are gross margin and overhead costs, which provide different but equally important insights into a company’s financial operations. Understanding the distinct nature of these terms is a starting point for analyzing a company’s profitability. Their calculations reveal how efficiently a company generates value and manages its expenses.
Defining Gross Margin
Gross margin does not include overhead costs. Instead, it is a measure of profitability calculated by subtracting the Cost of Goods Sold (COGS) from a company’s total revenue. This metric focuses exclusively on the profitability of the products or services themselves, before any other expenses are taken into account.
COGS encompasses all the direct costs associated with producing goods. The first is direct materials, which are the raw materials that become part of the final product. For a furniture maker, this would include the wood, screws, and varnish used to create a table.
The second component is direct labor, which includes the wages and benefits paid to the employees who are directly involved in the manufacturing process. This would be the salary of the carpenter who builds the furniture or the technician who operates the machinery. The final element is manufacturing overhead, which includes costs that are necessary for production but not tied to a specific unit. Examples include the rent for the factory, utilities for the production facility, and the depreciation of manufacturing equipment.
Understanding Overhead Costs
Overhead costs are the expenses incurred to keep a business running that are not directly related to the production of goods or services. These are often referred to as Selling, General, and Administrative (SG&A) expenses. Unlike COGS, which fluctuates with production levels, many overhead costs are fixed or semi-variable.
While the factory rent is part of COGS, the rent for the corporate headquarters is an overhead cost. Similarly, the salaries of sales teams, marketing personnel, human resources staff, and corporate executives are all considered SG&A expenses. Other common examples include advertising campaigns, office supplies, legal fees, and accounting services.
These expenses are essential for the company’s operations and long-term growth, but they do not directly contribute to the creation of a single product. For instance, a marketing campaign is designed to drive sales for all products, not just one specific item.
Calculating Key Profitability Metrics
The distinct roles of COGS and overhead become clear when calculating a company’s full range of profitability metrics. By using a simple example, we can see how gross margin is just one step in determining a company’s ultimate profitability. These calculations are typically presented on a company’s income statement, a standard financial document.
Consider a hypothetical company with the following annual figures: Total Revenue of $100,000, COGS of $40,000, Overhead (or Operating Expenses) of $25,000, and Taxes of $10,000. The first step is to calculate the Gross Profit, which is Revenue minus COGS. In this case, $100,000 – $40,000 equals a Gross Profit of $60,000. The Gross Margin is this profit expressed as a percentage of revenue, so ($60,000 / $100,000) 100, which results in a 60% Gross Margin.
Next, to find the Operating Income, the overhead costs are subtracted from the Gross Profit. Here, $60,000 – $25,000 gives an Operating Income of $35,000. This figure represents the profit from core business operations before interest and taxes. The Operating Margin is then calculated as ($35,000 / $100,000) 100, which is 35%. This metric shows how efficiently a company is being run from an operational standpoint.
Finally, to arrive at Net Income, other expenses like taxes are subtracted from the Operating Income. Using our example, $35,000 – $10,000 in taxes results in a Net Income of $25,000. The Net Margin, which reflects the company’s overall profitability after all expenses are paid, is ($25,000 / $100,000) 100, or 25%.