Definition
Gross margin measures how much of a company's revenue remains after subtracting cost of goods sold (COGS) or the equivalent direct costs associated with delivering that revenue.
It is expressed as a percentage:
Gross Margin = (Revenue − COGS) ÷ Revenue × 100
For example, if a company generates $1 million in revenue and incurs $400,000 in direct costs:
($1M − $400K) ÷ $1M × 100 = 60%
The company therefore has a 60% gross margin.
Gross margin is different from operating margin and net margin because it focuses on the economics of delivering the product or service before other operating expenses such as sales, marketing, research and development, and general administration.
How is gross margin calculated?
The basic calculation is:
Gross Profit = Revenue − COGS
Then:
Gross Margin = Gross Profit ÷ Revenue × 100
For example:
Metric | Amount |
|---|---|
Revenue | $2,000,000 |
COGS | $800,000 |
Gross profit | $1,200,000 |
Gross margin | 60% |
The exact classification of costs as COGS can depend on the company's business model and applicable accounting framework.
What is included in COGS?
COGS generally includes costs directly associated with producing or delivering the revenue-generating product or service.
Depending on the business, this may include:
Manufacturing costs
Raw materials
Inventory costs
Direct production labour
Hosting or infrastructure costs directly attributable to delivering a software service
Payment processing costs
Other directly attributable delivery costs
The appropriate classification varies by business model and accounting framework.
For example, a software company may treat certain cloud infrastructure costs as costs of revenue, while a manufacturing company may have substantial raw-material and production costs.
Gross margin vs. gross profit
These terms describe the same underlying economics but in different forms.
Gross profit is the absolute amount remaining after COGS.
Gross margin expresses that amount as a percentage of revenue.
For example:
Revenue: $1 million
COGS: $400,000
Gross profit: $600,000
Gross margin: 60%
Gross profit tells you how much remains.
Gross margin tells you what proportion of revenue remains.
Why does gross margin matter?
Gross margin helps show how economically attractive a company's core product or service is before operating expenses.
A higher gross margin can provide more revenue to fund:
Research and development
Sales and marketing
General administration
Customer support
Further growth
Debt obligations
Other operating activities
However, a high gross margin does not automatically mean a company is profitable.
A company with a 90% gross margin can still lose money if its operating expenses are substantially higher than its gross profit.
Gross margin by business model
Gross margins can vary substantially across industries.
Software
Software businesses can often have relatively high gross margins because the incremental cost of delivering additional software customers can be comparatively low.
Manufacturing
Manufacturers generally incur material, production, logistics, and other direct costs that can result in lower gross margins.
Retail
Retail margins depend heavily on wholesale costs, product pricing, inventory, and other direct costs.
Marketplaces
Marketplace economics can be more complicated because the company may facilitate transactions without recognising the entire transaction value as revenue.
The relevant comparison is therefore usually between companies with similar business models, rather than across unrelated industries.
Gross margin and scalability
Gross margin is particularly important when assessing whether a business model can scale efficiently.
Suppose two companies each generate $1 million in revenue.
Company A
Gross margin: 80%
Gross profit: $800,000
Company B
Gross margin: 30%
Gross profit: $300,000
If both companies grow revenue by another $1 million, Company A has substantially more gross profit available to fund its operating expenses.
However, gross margin alone does not establish scalability. Customer acquisition costs, retention, operating expenses, capital requirements, and other factors also matter.
Gross margin and SaaS
For subscription software businesses, investors may pay particular attention to gross margin because recurring revenue combined with strong gross margins can create attractive operating leverage as the business grows.
Relevant costs can include expenses directly associated with delivering the software service, such as infrastructure or third-party services, depending on the company's accounting methodology.
A SaaS company should use a consistent definition of cost of revenue so that its gross margin can be meaningfully tracked over time.
Gross margin vs. markup
Gross margin and markup are related but different.
Gross margin measures gross profit as a percentage of selling price or revenue.
Markup measures the increase over cost.
For example, if a product costs $60 and sells for $100:
Gross profit = $40
Gross margin = $40 ÷ $100 = 40%
Markup = $40 ÷ $60 = 66.7%
Confusing these two percentages can lead to incorrect pricing or financial analysis.
What can change gross margin?
Gross margin can change because of:
Pricing changes
Supplier costs
Manufacturing costs
Infrastructure costs
Product mix
Discounts
Customer mix
Shipping or fulfilment costs
Operational efficiency
Economies of scale
A company's gross margin can therefore increase even without raising prices if it reduces the direct cost of delivering its product.
Conversely, rapid growth can sometimes reduce gross margin if the company enters lower-margin markets or incurs higher delivery costs.
Gross margin and fundraising
Investors may use gross margin to evaluate the quality and scalability of a company's revenue.
For example, two companies with identical revenue growth can have very different economics if one has a substantially higher gross margin.
Investors may consider gross margin alongside:
Revenue growth
Customer acquisition cost
Retention
Churn
Burn rate
Operating expenses
Unit economics
Gross margin is therefore one component of a broader assessment rather than a standalone measure of investment quality.
Example
A software company generates $3 million in annual revenue.
Its direct costs of delivering the software are $900,000.
Its gross profit is:
$3M − $900K = $2.1M
Its gross margin is:
$2.1M ÷ $3M × 100 = 70%
The remaining $2.1 million is available to cover operating expenses and, if sufficient, generate operating profit.
Common misconception
A higher gross margin always means a better business.
Not necessarily.
Gross margin is an important indicator of business economics, but it does not capture every cost required to build and operate a company.
A business with a lower gross margin can still be highly attractive if it has strong growth, efficient operations, excellent retention, or significant competitive advantages.
The appropriate gross margin depends heavily on the company's industry and business model.
