Gross margin is the percentage of revenue that remains after deducting the cost of goods sold (COGS). It shows how much profit you make on each dollar of sales before accounting for operating expenses, interest, and taxes.
Interpretation: For every $1 in sales, you keep $0.60 after covering the direct cost of the product. This $0.60 must cover all other expenses (rent, salaries, marketing) and leave room for profit.
COGS includes only the direct costs of producing or acquiring the products you sell:
Ask yourself: "Would this cost exist if I didn't make or sell this specific product?" If yes, it's COGS. If the cost exists regardless (like rent), it's an operating expense, not COGS.
| Industry | Typical Gross Margin | Notes |
|---|---|---|
| Software/SaaS | 75-90% | Very low COGS (servers, hosting) |
| Consulting | 60-80% | Main cost is labor |
| Restaurants | 60-70% | Food cost is 30-40% of sales |
| Retail clothing | 40-60% | Markup varies by brand positioning |
| Manufacturing | 25-40% | High material and labor costs |
| Grocery stores | 20-30% | High volume, low margin |
| Auto repair | 50-65% | Parts + labor model |
Don't confuse gross margin with gross markup. If a product costs $40 and sells for $100:
- Gross Margin = 60% (profit as % of selling price)
- Gross Markup = 150% (profit as % of cost)
These are different! Margin is always lower than markup for the same product.
| Metric | What It Measures | Calculation |
|---|---|---|
| Gross Margin | Product-level profitability | (Revenue - COGS) / Revenue |
| Net Profit Margin | Overall business profitability | Net Income / Revenue |
The company has a healthy 60% gross margin but only 9.1% net profit margin due to operating expenses. This is normal - gross margin is always higher than net profit margin.
Boutique Clothing Store
| Product Line | Revenue | COGS | Gross Profit | Gross Margin |
|---|---|---|---|---|
| Dresses | $80,000 | $32,000 | $48,000 | 60% |
| Shoes | $45,000 | $22,500 | $22,500 | 50% |
| Accessories | $25,000 | $7,500 | $17,500 | 70% |
| Total | $150,000 | $62,000 | $88,000 | 58.7% |
Web Design Agency
Service businesses typically have high gross margins because COGS is mainly labor (no physical product costs).
Current Situation:
After 10% Price Increase:
A 10% price increase improved gross margin by 5.5 percentage points!
Options to Lower COGS:
Example:
Sell more high-margin products, fewer low-margin products.
| Product | Gross Margin | Current Sales | Target Sales |
|---|---|---|---|
| Premium Line | 65% | 30% | 40% |
| Standard Line | 45% | 50% | 45% |
| Budget Line | 25% | 20% | 15% |
By shifting sales toward premium products (even slightly), overall gross margin improves without changing individual product margins.
Sometimes the best way to improve margin is to stop selling unprofitable products.
Higher margins don't always mean more profit. Sometimes lower margins with higher volume win.
Before cutting prices to boost volume, calculate your break-even point:
If you cut price 20%, you need volume to increase by at least 33% just to maintain the same gross profit. Make sure you can actually achieve that volume increase!
Situation: A cafe wants to understand profitability across different products.
| Item | Price | COGS | Gross Profit | Margin |
|---|---|---|---|---|
| Flat White | $5.00 | $0.80 | $4.20 | 84% |
| Muffin | $4.50 | $1.20 | $3.30 | 73% |
| Sandwich | $9.50 | $4.00 | $5.50 | 58% |
| Smoothie | $7.50 | $2.50 | $5.00 | 67% |
Situation: Online retailer must decide between two pricing strategies.
| Metric | Option A | Option B |
|---|---|---|
| Gross Margin | 62.5% | 49.4% |
| Monthly Revenue | $24,000 | $35,600 |
| Monthly Gross Profit | $15,000 | $17,600 |
| Profit per Unit | $75 | $44 |
Option B wins on total gross profit ($17,600 vs $15,000) despite lower margin. However, Option A requires fulfilling 50% fewer orders (200 vs 400), which means lower shipping costs, packaging costs, and customer service workload. The final choice depends on operational capacity and strategic goals.
Situation: Manufacturer finds ways to reduce COGS without changing price.
| Action | Old Cost | New Cost | Savings |
|---|---|---|---|
| Negotiated bulk material purchase | $180 | $162 | $18 |
| Process improvement (15% faster) | $90 | $78 | $12 |
| Cheaper packaging supplier | $30 | $25 | $5 |
| Total | $300 | $265 | $35 |
Situation: Consulting firm faces margin pressure from rising labor costs.
| Option | Action | Result |
|---|---|---|
| 1. Raise prices | Increase fee to $115,000 | 60% margin restored |
| 2. Improve efficiency | Complete in 700 hours instead of 800 | 58% margin (better than 52%) |
| 3. Mix junior/senior staff | Use more junior consultants at $45/hour | Back to ~60% margin |
| 4. Do nothing | Accept 52% margin | Reduced profitability |
The firm chose Option 3 (staff mix) for ongoing work and Option 1 (price increase) for new clients, restoring margins to healthy levels.
Complete this 10-question quiz to check your understanding of Gross Margin
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