What is gross margin and what should mine be?

How gross margin is calculated

The formula is straightforward: gross margin equals (revenue minus cost of goods sold, or COGS) divided by revenue. If a business sells $100,000 of product and the direct cost of that product was $60,000, gross margin is 40%. The percentage tells you how much of each sales dollar remains before general overhead, selling costs, and profit come into play.

Gross margin sits above the income statement's other expense lines. Rent, marketing, administrative salaries, and interest all come out after gross margin, on the way down to net profit. A healthy gross margin does not guarantee a healthy net margin if overhead is too heavy for the business's size.

This is why two businesses with the same gross margin can end up in very different financial positions. One with lean overhead keeps most of that margin as profit, while another carrying a large office, a big administrative team, or heavy marketing spend can turn the same gross margin into a thin or negative bottom line. Gross margin measures how the product or service itself performs; net margin measures how the whole business performs.

What actually belongs in cost of goods sold

What counts as COGS depends heavily on the type of business, and getting this wrong is the most common reason two businesses' gross margins are not actually comparable. For a business that sells physical product, COGS typically includes the product cost itself, inbound freight, and direct labour involved in producing or assembling it. For a service business, COGS is usually the labour directly delivering the billable service, not the owner's time spent on sales or administration. For a software or subscription business, COGS is often narrower still: hosting costs, payment processing fees, and customer support tied directly to serving existing customers.

Costs that do not vary directly with each sale, rent, marketing, most administrative salaries, generally belong below the gross margin line, in operating expenses, not inside COGS. Businesses that lump too much into COGS end up with an artificially thin gross margin that makes pricing decisions harder to read correctly.

A consistent definition matters more than a perfect one. Whatever a business decides belongs in COGS, applying that definition the same way month after month is what makes the trend line meaningful; changing the definition partway through the year, even for a good reason, makes it much harder to tell whether margin genuinely improved or simply got redefined.

Why there is no single target number

Gross margin benchmarks vary enormously by industry, and quoting a specific target percentage without knowing the business model would be misleading. A business reselling physical inventory it did not manufacture typically runs a thinner gross margin than a business built around labour or expertise, since the resold product itself is the largest direct cost. A software business typically runs a much wider gross margin than either, since serving one more customer usually costs very little once the product exists. Within any of these categories, purchasing power, pricing strategy, and operational efficiency still create real differences from one business to the next.

Rather than chasing an industry number pulled from somewhere online, we generally recommend tracking your own gross margin trend month over month and investigating any meaningful move, up or down, rather than comparing directly to a competitor whose cost structure may look nothing like yours.

Gross margin versus contribution margin

Gross margin and contribution margin are related but not identical. Gross margin only subtracts COGS as it is defined on the income statement. Contribution margin subtracts every cost that varies directly with a sale, which sometimes includes items that sit below the gross margin line on the income statement, like sales commissions or shipping paid to the customer. Contribution margin tends to be the more useful number for pricing a specific product or deciding whether to accept a specific order, since it reflects everything that actually changes if that one sale happens or does not, which is also the number that ultimately feeds into calculating a break-even point.

The levers that actually move gross margin

Three levers move gross margin, and they rarely move it in isolation. Pricing is the most direct: raising price without raising cost improves margin immediately, though it carries demand risk. Purchasing is the second lever, better supplier terms, volume discounts, or reducing waste and shrinkage all lower COGS without touching price. Labour efficiency is the third, particularly for service businesses, where the time it takes to deliver the same service is often the single biggest driver of margin.

A business seeing gross margin slide should check all three before assuming the answer is simply "raise prices": sometimes the real driver is a supplier cost that crept up unnoticed, or a service that now takes longer to deliver than it used to.

Waste and shrinkage deserve their own mention. A product business losing a small percentage of inventory to damage, theft, or spoilage every month may not notice the loss anywhere on the income statement directly, but it shows up quietly in a gross margin that never quite matches what the pricing model predicted, month after month, without an obvious single cause.

How we help clients read this number

As part of our CFO advisory work, we usually start by confirming what is actually sitting in a client's COGS, since that alone often changes the margin picture before any pricing conversation happens, then track the trend monthly alongside the other KPIs that matter for that business.