For business owners and investors, gross margin is one of the clearest signals of operational efficiency. A company with a higher gross margin keeps more money from each sale to cover administrative expenses, invest in new products and generate net profit.
By tracking gross margin alongside other key performance indicators, founders avoid the trap of growth at all costs and build a business model that supports long-term success.
Gross margin connects revenue, direct costs and the bottom line into one simple measure of a company's financial health.
What gross margin measures (and how to calculate it)
Gross margin lives on the income statement. It's calculated by taking total revenue (or net sales) and subtracting the direct costs associated with making and selling a product. These direct costs are known as the cost of goods sold (COGS) or cost of sales. COGS can be a significant factor in the cost equation for some companies (eg, CPG companies) and less so for others (eg, SaaS).
COGS includes expenses tied directly to the production process:
- Raw materials: The basic components used to create a product.
- Direct labor costs: Wages for workers involved in production.
- Manufacturing overhead: Rent, utilities and equipment depreciation
What isn't included are indirect operating expenses like salaries, administrative expenses or R&D. Gross margin isolates the profitability of the core product itself before any other business costs are factored in.
Gross profit is the dollar amount left after subtracting COGS. Gross margin is that same number expressed as a percentage of revenue.
Gross margin expresses gross profit as a percentage of revenue:
Gross margin = (net sales – COGS) / net sales × 100
Example: If sales revenue is $200,000 and direct costs are $100,000, gross profit is $100,000. In this instance, the gross margin is 50%.
Gross profit is a dollar figure. Gross margin is a percentage of revenue. Both matter: one shows absolute dollars available, the other shows efficiency relative to sales.
Why gross margin matters for financial health
Gross margin is more than a number. It reflects pricing power, cost control and the strength of your business model.
- For manufacturing companies, gross margin highlights how well you manage raw materials and labor costs. A falling margin may point to inefficiencies in the production process.
- For SaaS and service businesses, gross margin shows whether recurring revenue can support growth without ballooning costs of production.
- For startups, gross margin is a guardrail. It prevents over-investment in sales or marketing when the unit economics don't support it.
Gross margin is a mirror: it reflects whether your operations are efficient enough to support growth.
What is a good gross margin?
There is no universal standard for a good gross margin. It varies significantly based on the industry average and business model.
- SaaS and software companies often have very high gross margins, frequently between 70% and 90%. Their COGS are low since delivering software involves minimal variable costs per customer.
- Retail and manufacturing companies typically have lower gross margins, from 20% to 50%. Their COGS are high due to significant spending on raw materials, physical inventory and direct labor costs.
The best approach is to compare your gross margin percentage against an industry benchmark. Analyzing your numbers in context helps you and potential investors understand if your company's profitability is competitive.
Using gross margin for strategic decisions
Smart founders use gross margin as a diagnostic tool. When understood in context and mapped over time, your gross margin can become a useful KPI for developing:
- Pricing strategy: If competitors have higher gross margins, you may be underpricing or overspending on inputs. If your margins are far above industry benchmarks, you may have room to lower prices to expand your customer base.
- Product portfolio: Compare gross margin per unit across SKUs. Double down on high-margin products and reconsider low-margin ones.
- Cost management: A declining margin signals the need to renegotiate supplier terms, automate parts of the production process or cut variable costs.
- Growth planning: Higher margins provide more resources to invest in new direction initiatives, like new products or market expansion.
Gross margin is the fastest way to see if your pricing and cost structure are working together.
How to improve your gross margin percentage
Improving your company's gross margin percentage requires both cost discipline and pricing strategy.
- Audit variable costs: Identify your top five cost drivers in COGS and renegotiate terms where possible.
- Streamline production: Automate repetitive tasks, reduce waste and train teams to improve efficiency.
- Revisit pricing: Test higher prices with new customers, create premium tiers or bundle products to increase average transaction value.
- Focus on retention: For subscription businesses, reducing churn increases the lifetime value of each customer and improves gross margin over time.
- Shift product mix: Promote high-margin products more aggressively and phase out low-margin offerings.
Small efficiency gains compound into a stronger gross margin and healthier bottom line.
Gross margin analysis by business type
Different business models require different approaches to gross margin optimization:
E-commerce businesses should focus on inventory management and supplier relationships. Bulk purchasing agreements can reduce raw material costs. Dropshipping models typically have lower gross margins but require less upfront investment.
Service businesses often have higher gross margins since their primary cost is labor. The key is optimizing billable hours and reducing non-productive time. Productizing services through templates or frameworks can improve margins.
SaaS companies should track gross margin per customer segment. Enterprise customers often have higher margins due to annual contracts and lower support costs per dollar of revenue. Self-serve plans may have better unit economics despite lower absolute revenue per customer.
Track gross margin monthly by product line to spot trends before they impact your bottom line.
Gross margin in financial forecasting
You can use gross margin analysis to make smarter decisions about pricing, cost management and growth:
- Cut variable costs: Negotiate better terms on raw materials or automate parts of the production process
- Revisit pricing strategy: If margins fall below the industry average, test higher prices or new product tiers
- Prioritize high-margin products: Focus sales and marketing on goods or services with higher gross margins
- Track per-unit margins: For companies with multiple SKUs, calculate gross margin per unit to see which products drive profitability
Startups that rely on rigid annual planning often miss these signals. A more flexible approach, like the rolling planning system described in "Annual Planning is Killing Your Growth," helps leaders adjust when margins shift.
Track gross margin by SKU monthly and flag any product that drops more than three percentage points.
Gross margin is your foundation for growth
Gross margin is one of the clearest metrics for understanding if each dollar of revenue is contributing to sustainable growth.
A higher gross margin provides the financial flexibility to invest in research, marketing and talent. By tracking gross margin against industry benchmarks and using it to inform your pricing and cost management strategies, you ensure your business is not just growing but growing profitably.
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