Do You Really Understand Gross Margin?

If you're an entrepreneur, investor, or operator, you’ve probably heard that gross margin is a critical metric.

But how deeply do you really understand this metric?

Most business people understand that higher margins are generally better.

But do they know how significant small increases in gross margins can be?

Small changes in gross margin can have massive impacts on your business's profitability and efficiency.

Most business owners should focus on improving gross margins to make their business stronger.

Let’s break it down.

A quick recap of the accounting fundamentals

Gross margin is what is left over of revenue after you subtract the direct costs of delivering your product or service. These costs are called Cost of Goods Sold (COGS) or Cost of Sales (COS). These costs include the direct material, labor, and overhead expenses needed to make the product or provide the service.

For example, if you sell something for $100 and it costs you $40 to produce it, your gross profit is $60. Your gross margin (which is gross profit as a percentage of revenue) is 60%. This means you keep $60 out of every $100 in sales to pay for other expenses, invest in the business, or keep as profit.

Gross margins and business characteristics

Gross margins can tell you a lot about a business. Especially when you compare gross margins to asset turnover, which shows how much sales a business makes from a given level of assets.

Successful businesses have a healthy trade-off between gross margins and asset turnover. Low gross margin businesses should either improve its gross margins or its asset turnover.

Most small businesses experience low gross margins and low turnover, which is problematic.

The matrix below demonstrates the dynamic between gross margins and turnover.

In general, high gross margin businesses have some kind of differentiation. Software and media typically have high gross margins because technology allows for mass distribution with almost no incremental cost.

Low gross margin businesses that are large and successful are the low cost producers. Their low margins ensures they have the highest level of sales, and make their returns on sheer volume.

I believe that most businesses need to find ways to increase their gross margin.

This is because it doesn’t pay to be the second cheapest player in a market.

The low-cost producer will win the lion’s share and will dominate the lower end of the market. They can do this because they’ve spent years building the systems and infrastructure that lets them handle big volumes at low costs.

90% (or more) of businesses are not the low-cost producers. They need to find ways to improve gross margins. This usually means pricing their products or services more intelligently.

Note: There is a right way to increase prices, and businesses need to approach this exercise with caution. How a business raises prices depends on the type of business and its relationship with its customers.. The topic of pricing is outside the scope of this post.

Demonstrating the impact of small changes to gross margin

1)       Non-Linear Efficiency Gains

Consider going from 80% gross margin to 90%.

That ’10-point’ (or 12.5% percent) different may seem small, but its actually a 100% efficiency gain.

Let me demonstrate.

Let’s define efficiency as revenue divided by direct cost. It tells you how much money you make for every dollar you spend on direct costs.

Suppose you run a business that sells something for $100.

• At 80% gross margin, your cost is $20 and your profit is $80. The efficiency ratio is 100/20, which is 5x.

• At 90% gross margin, your cost is just $10 and your profit is $90. The efficiency ratio is 100/10, which is 10x.

Going from a 5x efficiency ratio to 10x is a 100% improvement.

2)       Non-Symmetrical Gross Profit Improvements

Now let me show how changing a product or service’s markup can have a big impact on gross profit.

When a business increases its markup from 2x to 3x (a 50% increase) gross margin rises from 50% to 67% (a 17-point or 33% gain).

But the real impact to the P&L is more dramatic. Total gross profit doubles, going from $100 to $200.

Now lets see what happens when the mark-up is reduced.

Assume a business reduces its markup from 2x to 1.5x (a 25% decrease). Gross margin drops from 50% to 33%. The result is actually worse than it initially seems. Total gross profit gets cut in half, falling from $100 to $50.

When your business has high fixed costs (like staff, rent, or software) the drop in gross margin hits harder.

Gross profit shrinks fast, but operating expenses stay mostly the same.

Worse, if you lower your markup, you may need to serve more customers who are now less valuable to your business. Having more customers at this point would workload and possibly operating costs. This would result in a bigger hit to EBITDA than to gross margins.

TL;DR:

Gross margin is one of the most important (and least understood) metrics in business.

Gross margins reveal a lot about the characteristics of a business, especially when compared to asset turnover.

Most small businesses have both low gross margins and low asset turnover. This puts them at a structural disadvantage. They should focus on improving gross margins, not asset turnover, because they probably can’t compete with the low-cost, high-volume businesses. (If you want to sell furniture, are you really going to try and compete directly with Ikea?)

What most people miss is that changes in gross margin have nonlinear, asymmetric effects:

• Going from 80% to 90% gross margin increases efficiency by 100%.

• Increasing your markup by 50% (from 2x to 3x, for example) can double gross profit.

• Reducing your markup by just 25% can cut gross profit in half.

If your business has high fixed costs, changes in gross margin will have an even bigger impact on the bottom line.

My suggestion: Keep your eye on gross margin.

Don’t race to the bottom.

Instead, find ways to raise your margin. Even if its by a little.

Over time, it can completely reshape your business’s performance.

If you found this helpful, please share it with a fellow builder or operator. And if you have your own lessons or frameworks around gross margin, I’d love to learn from you. Feel free to reach out on LinkedIn.