Explaining gross margin — and why it may matter more than revenue

After a lot of sleepless nights and hard work, your startup finally hits $1 million in revenue. You’re feeling ready to pop open some champagne, but before you get a chance, your investors ask about your company’s gross margin. And those numbers, it turns out, aren’t quite as celebration-worthy. The reason investors ask about gross margin is simple. When it comes to your company’s success, sales growth alone doesn’t tell the whole story. Revenue measures scale, but you’ll also need to understand business sustainability — and that’s what gross margin measures. Think of it this way: Revenue can look impressive, but gross margin will better tell the truth about your business’ health. 

We’ll further explain the ins and outs of gross margin in this article. By the end, you’ll know how to calculate it and grasp the difference between gross margin vs. revenue, as well as other key margin metrics. You’ll also understand why gross margin matters more than topline growth when evaluating business durability and scalability.

Gross margin measures how much revenue remains after covering the direct costs of delivering your product or service.

A higher gross margin means that your business makes a larger profit from every dollar of sales, whereas a lower gross margin is a sign that you need to start trimming costs or raising prices.

To calculate your startup’s gross margin, here’s the gross margin formula:

Gross margin = (Revenue – cost of goods sold) ÷ revenue x 100

To put this formula into action, let’s take a look at a few common examples by company type.

Example: SaaS company

With 500 customers on a $100 per month subscription, this startup earns $50,000 in monthly revenue. Its direct costs are $15,000 per month, including cloud hosting, salaries for customer support personnel, and third-party APIs.

($50,000 - $15,000) ÷ $50,000 x 100 = 70 

So, this SaaS company has a gross margin of 70%.

Example: E-commerce brand

This direct-to-consumer brand sells 2,000 units each month at $50 per unit, giving it monthly revenue of $100,000. The company’s cost of goods sold is $50,000 per month, which includes manufacturing, packaging, and shipping.

($100,000 - $50,000) ÷ $100,000 x 100 = 50 

So, this e-commerce brand has a gross margin of 50%.

Example: Services firm

A marketing agency has 10 clients each on a $20,000 retainer per month, bringing in $200,000 of monthly revenue. The firm’s direct costs are $94,000, made up primarily of payroll costs.

($200,000 - $94,000) ÷ $200,000 x 100 = 53 

So, this services firm has a gross margin of 53%.

Understanding the difference between gross revenue vs. gross margin can be a source of confusion for new founders. Revenue and gross margin are both important metrics, but they represent different aspects of your business.  

Here’s how gross margin vs. revenue compare:

• Revenue measures the total sales for your business.
• Gross margin measures the profitability of those sales. 

It’s possible for a startup to have revenue growth while still having weak margins. How? Discounted pricing, high direct costs, and operational inefficiencies are some of the common reasons gross margins can deteriorate for startups. Other levers include customer mix changes and product shifts toward lower-margin offerings. 

While you should certainly pay attention to your company’s revenue growth, also keep a strict eye on your gross margin because it indicates the health of your business. Strong startups maintain or improve their margins as they scale. Weak startups, on the other hand, have fragile unit economics that need to be better controlled.

Another area of head-scratching for some founders is understanding the differences between gross margin vs. gross profit. Though these terms sound like the same thing (and they almost are), there’s a key difference. 

Here’s how gross margin vs. gross profit compare:

• Gross profit is the dollar amount left over after subtracting the cost of goods sold (COGS) from your revenue.
• Gross margin is the percentage of revenue that remains after subtracting the cost of goods sold from your revenue.

Example: E-commerce brand

To see how this plays out in real life, let’s take the e-commerce brand example from above, which has:

• Revenue: $100,000
• COGS: $50,000

If we calculate this company’s gross margin vs. gross profit, here’s what we’ll get:

• Gross profit: $100,000 - $50,000 = $50,000
  Gross margin: ($100,000 - $50,000) ÷ $100,000 x 100 = 50%

The takeaway: Essentially, gross margin tells you a percentage, and gross profit tells you an absolute dollar amount.

Now, it’s time to get into layered profitability. Picture profitability like a ladder. As you climb each rung, you’ll learn something new about the health and sustainability of your business. The first rung on that ladder is gross margin. It shows if your business model works and whether or not you have a pricing or cost problem. You should pay attention to this profitability metric first. 

The last rung on the ladder is net margin, which illuminates your profitability after all expenses (not just the cost of goods sold) are subtracted from your revenue. 

Here’s the difference between gross margin vs. net margin:

• Net margin takes into account all expenses, including taxes, interest, marketing, rent, software, and one-time costs.
• Gross margin takes into account only the direct cost of goods sold, such as materials, direct labor, and fulfillment.

We’re going to keep climbing the profitability ladder, with gross margin at the bottom and net margin at the top. After gross margin, we reach contribution margin, which measures the revenue that remains after subtracting the COGS and variable operating costs. Variable operating costs are essentially any costs that increase as you sell more products or services. 

Here’s the difference between contribution margin vs. gross margin:

• Contribution margin takes into account COGS and variable costs, such as ads, sales commissions, and payment processing fees.
• Gross margin takes into account only the direct cost of goods sold, such as materials, direct labor, and fulfillment. 

Contribution margin is an important indicator of the sustainability of your startup’s growth. If you have strong gross margins but weak contribution margins, it means that your product is viable but your growth engine isn’t.

The next step on the profitability ladder after contribution margin is operating margin. This metric indicates the efficiency of your business by measuring the percentage of revenue that’s left after subtracting COGS, variable costs, and fixed costs, but not taxes or interest. 

Here’s the difference between gross margin vs. operating margin:

• Operating margin takes into account COGS, variable costs, and fixed costs, such as marketing, admin, rent, and research and development (R&D).
• Gross margin takes into account only the direct cost of goods sold, such as materials, direct labor, and fulfillment. 

If you have strong gross margins but weak operating margins, it may mean that your marketing spend is too high or that your administrative costs are ballooning. Tracking operating margin can help you keep your startup’s operations disciplined as you scale.

For startup founders, revenue is often seen as the holy grail of metrics. However, in terms of importance, gross margin should also be high on your list. 

Gross margin determines your startup’s scalability, influences burn multiple (how much cash you’re burning to generate revenue), and impacts valuation multiples. It also determines how much your business can strategically spend on your growth to reach the next stage of success. 

If two companies have equal revenue, but one has a strong gross margin and the other has a weak gross margin, which business do you think is more sustainable? The startup with a strong gross margin is durable, and keeps more of every dollar to reinvest in growth. The startup with a weak gross margin is less flexible, carries higher risk, and won’t be able to sustain its success over the long term, unless it makes some changes.

As you’ve probably determined from what we’ve covered above, a “good” gross margin is relative based on a number of factors heavily impacted by the industry you’re in. The stage of your business and your product strategy can also have an effect on what’s considered good for your business. Here are some industry benchmarks to note.

SaaS gross margin benchmark: 65-90%

SaaS startups have a high gross margin because they have high upfront development costs, but low incremental delivery costs. Early-stage SaaS startups will fall in the lower end of this range, but can expect higher growth margins as they scale.

Marketplace gross margin benchmark: 60-80%

Because marketplaces don’t hold inventory, their gross margin can be higher than that of a typical e-commerce company. Early-stage startups may have a lower gross margin that will likely improve with growth.

E-commerce gross margin benchmark: 35-60%

E-commerce startups have a high cost of goods sold and margins depend heavily on pricing strategy. It’s important for early-stage founders to keep an eye on gross margin to prevent cash flow issues, which can hinder expansion.

Services gross margin benchmark: 30-70%

There’s a huge variance in gross margin among services firms, since the primary cost of goods sold is human time. Your pricing structure matters greatly as do the number of billable hours you have. Early-stage founders need to work on labor efficiency to drive up gross margin.

Hardware company: 30-60% 

With high material, logistics, manufacturing, and warranty costs, margins can be lower for hardware startups compared to SaaS businesses. Costs scale with each unit, so it can be difficult to increase gross margin for early-stage businesses.

Revenue highlights growth, and gross margin reflects your company’s long-term sustainability. Don’t get too caught up on revenue alone though. Ignoring your gross margin could lead to unnecessary fragility, such as a faster cash burn, cash flow issues, and a constant need to fundraise. 

Calculate and monitor your gross margin monthly, so you can stay informed and track your company's pricing power, cost discipline, and ability to scale. Your startup will thank you in the long run.