If you could look at only one number to judge the strength of a business, gross margin would be a strong candidate.
Gross margin is gross profit divided by revenue: the share of each sales dollar left after paying the direct cost of the product or service. Sell something for $100 that costs $30 to make, and the gross margin is 70%.
It sounds like an accounting detail. It is really a measure of how much customers are willing to pay for what you offer compared with what it costs you to provide it. That makes it one of the clearest windows into pricing power, competitive position and the economics of a business. This article explains how to calculate and read gross margin, what the book Warren Buffett and the Interpretation of Financial Statements suggests about it, the caveats that matter, and how founders can design for healthy margins from the start.
Calculating gross margin
The calculation is simple:
Gross margin = (Revenue − Cost of goods sold) ÷ Revenue
Cost of goods sold (sometimes called cost of sales) includes the direct costs of producing what you sell: materials, components, direct labour, manufacturing overheads, freight in, and for some service businesses the direct cost of delivering the service. It excludes indirect costs such as office rent, sales and marketing, and administration, which appear lower in the income statement.
An illustrative example:
| Amount | |
|---|---|
| Revenue | $2,000,000 |
| Cost of goods sold | $1,100,000 |
| Gross profit | $900,000 |
| Gross margin | 45% |
Margin is not markup
One of the most common confusions in small business is between margin and markup. They describe the same relationship from different angles.
- Markup is profit as a share of cost. A product that costs $60 and sells for $100 has a markup of $40 ÷ $60 = about 67%.
- Margin is profit as a share of price. The same product has a margin of $40 ÷ $100 = 40%.
| Markup on cost | Resulting gross margin |
|---|---|
| 25% | 20% |
| 50% | 33% |
| 67% | 40% |
| 100% | 50% |
| 200% | 67% |
Businesses that price by adding a markup often believe their margins are higher than they are. A “50% markup” sounds healthy but produces only a 33% margin, which may not cover overheads. Knowing the difference is basic but surprisingly important.
What the number tends to reveal
The book offers rough bands, drawn from the kinds of companies Buffett favoured:
| Consistent gross margin | What it often suggests |
|---|---|
| 40% or more | The business may have some durable advantage, such as a brand, a unique service or a strong market position |
| Between 20% and 40% | Competition is eroding margins; the advantage, if any, is weaker |
| 20% or less | A fiercely competitive industry where price is the main weapon |
The authors stress the word consistent. A single year of high margins can come from a lucky product cycle or a temporary shortage. Ten years of high margins is much harder to explain without a genuine advantage.
Why high margins usually mean an advantage
Margins are high when competitors cannot easily undercut you. That happens when customers prefer your product for reasons other than price: trust, habit, quality, convenience or the cost of switching. It also happens when you have structural cost advantages others cannot match.
Low margins are the natural result when customers see little difference between suppliers. Each competitor cuts price to win the next order, and margins drift towards the minimum needed to survive.
There is a useful way to think about this. Gross margin measures the gap between what customers will pay and what the product costs. That gap exists only because of something customers value that others cannot provide as cheaply. The bigger and more persistent the gap, the stronger that “something” must be.
Reading margin trends
The direction of gross margin over time is often more informative than its level.
Stable high margins suggest an established advantage.
Gradually declining margins can be an early warning: competitors catching up, customers becoming more price-sensitive, or input costs rising faster than the business can pass them on. Profits may still look healthy for a while, but the trend suggests the advantage is weakening.
Rising margins may reflect growing pricing power, a better product mix, economies of scale or lower input costs. It is worth understanding which, because some causes are durable and others temporary.
Volatile margins suggest a business exposed to factors it cannot control, such as commodity prices, exchange rates or competitive price wars.
The important caveats
Gross margin is a filter, not a verdict.
- A high margin can still be wasted. If overheads, research or interest consume most of the gross profit, little reaches the owners. The rest of the income statement still matters.
- Low-cost leaders break the rule on purpose. Some excellent businesses run deliberately thin margins on enormous volume. Their advantage is in cost, not price, and shows up elsewhere: in turnover, efficiency and steady earnings.
- Industries differ. Software, branded consumer goods and many services naturally have higher gross margins than manufacturing, construction or retail. Compare a business with its own history and with its direct competitors, not with companies in completely different industries.
- Accounting classification varies. Companies make different choices about what goes into cost of goods sold. One may include freight and warehousing; another may report them as operating expenses. Comparisons between companies need care.
- Mix matters. A business selling several products reports an average margin. A change in mix can move the average without any change in individual product economics.
Gross margin in a small business
For a small business, gross margin is one of the most useful numbers to know, and one of the most often misunderstood.
Know it by product or service
The overall margin hides which offerings make money. A common discovery when small businesses calculate margin by product is that a popular item earns very little, or even loses money once direct labour is counted properly, while a less visible product subsidises it.
Include all direct costs
Small businesses often underestimate cost of goods sold by leaving out direct labour, wastage, freight, packaging or payment fees. Calculating margin on materials alone produces a flattering but misleading figure.
Know what margin you need
Gross profit has to cover all overheads and leave a profit. A useful check is to work backwards: if annual overheads are $400,000 and you want $100,000 profit, you need $500,000 of gross profit. At a 40% margin, that requires $1.25 million of revenue; at a 25% margin, $2 million. Margin directly determines how much you must sell.
Gross margin in service businesses
Service businesses sometimes assume gross margin does not apply to them, because there is no physical product. It applies just as much. The direct cost of a service is usually the time of the people who deliver it, plus any direct materials, subcontractors or travel.
A consultancy that bills $200 an hour for a consultant who costs the business $90 an hour (including salary, superannuation and on-costs) earns a gross margin of 55% on billed time. But unbilled time matters too. If that consultant is billable only 60% of their paid hours, the effective direct cost per billed hour rises to $150, and the real gross margin falls to 25%. Utilisation (the share of paid time that is billed) is often the hidden driver of service margins.
For service businesses, tracking gross margin by client, project and service line reveals which work is genuinely profitable, and often prompts changes in pricing, scoping or the mix of work accepted.
A worked example
Two hypothetical coffee roasters each sell $1 million of coffee a year.
The first sells unbranded beans to cafés on price, competing with several larger roasters. Its gross margin is 25%, giving $250,000 of gross profit. After overheads of $220,000, it earns $30,000. Any increase in green coffee prices squeezes it badly, because cafés will switch supplier if it raises prices.
The second has built a recognised brand with its own blends, sells partly through its own café and online subscriptions, and supplies cafés that advertise the brand to their customers. Its gross margin is 55%, giving $550,000 of gross profit. Overheads are higher at $350,000, reflecting marketing and service, but it still earns $200,000. When coffee prices rise, it can pass on part of the increase because customers value the brand.
Same revenue, very different businesses. The difference starts at the gross margin line.
Designing for margin from the start
For a founder, gross margin is not just something to measure later. It is largely decided by early choices:
- What problem you solve. Customers pay more for solutions to frequent, costly or risky problems than for minor conveniences.
- How different the offer really is. If customers cannot tell you apart from the alternative, they will choose on price.
- What your direct costs are made of. Products with high material or labour content per unit leave less room than products whose cost is mostly in design and know-how.
- Who you sell to. Some customers value reliability and service; others buy only on price. Margins follow the customer you choose.
- How you sell. Selling through intermediaries such as wholesalers and retailers shares the margin with them. Direct channels keep more of it, but cost more to run.
Pricing on value
Many businesses price by adding a markup to cost. An alternative is to price on the value the customer receives. If a product saves a customer $50,000 a year, a price based on a fraction of that saving may be far higher than cost-plus pricing would suggest, and still be an excellent deal for the customer. Value-based pricing requires understanding the customer’s situation well, which connects pricing directly to the listening and qualifying skills described in GoCore’s sales series.
A useful exercise before building anything is to estimate the gross margin honestly. If it is thin, ask whether you can genuinely be the lowest-cost provider at scale. If the answer is no, the idea may need rethinking before any money is spent.
Common mistakes
Confusing markup with margin. It overstates profitability.
Leaving direct costs out. Labour, freight and wastage belong in cost of goods sold.
Looking only at the average. Product-level margins reveal what really makes money.
Comparing across industries. Margins differ naturally by business model.
Cutting price to grow. Lower margins require much higher volume to produce the same gross profit. A 10% price cut on a 30% margin product requires roughly 50% more volume just to stand still.
That last point is worth checking. On a $100 product with $70 of direct cost, gross profit is $30. Cut the price by $10 and gross profit falls to $20, so you need one and a half times the volume to earn the same $30 per original sale.
Questions to ask
- What is the gross margin, and how has it moved over ten years?
- How does it compare with direct competitors?
- What allows the business to charge above its costs, and how durable is that?
- For your own business: what is the margin on each product, including all direct costs?
- What margin do you need to cover overheads and earn a reasonable profit?
- If input costs rose by 10% tomorrow, could you pass the increase on to customers, or would you have to absorb it?
- Which of your products or services would you stop offering if you saw their true margin?
The question about passing on cost increases is a particularly good test of pricing power. Businesses with a genuine advantage can usually raise prices modestly without losing many customers. Businesses without one find that every cost increase comes straight out of their margin.
Bringing it together
Gross margin measures the gap between what customers will pay and what it costs to serve them. Consistently high margins usually signal some form of advantage; consistently low ones usually signal a price-driven market. The level matters, the trend matters more, and both need to be read in context: industry, accounting choices, product mix and the rest of the income statement.
For founders, gross margin is a design decision as much as a result. The problems you choose, the customers you serve and the way you differentiate largely determine it before the first sale is made.
Source: Mary Buffett and David Clark, Warren Buffett and the Interpretation of Financial Statements (2008). Figures in this article are illustrations, not data. This article is general information, not financial or investment advice.
