Gross Margin Explained

Gross margin is the first number that shows whether a company's core product actually makes money before anything else gets paid.

The formula

Gross margin equals revenue minus cost of goods sold (COGS), divided by revenue, expressed as a percentage. COGS covers the direct costs of producing what a company sells — raw materials and manufacturing labor for a hardware maker, hosting costs for a software company, inventory and freight for a retailer.

Everything else — marketing, R&D, administrative overhead, interest — sits below gross margin and gets subtracted later, on the way to operating income and net income.

What it reveals about pricing power

A high gross margin usually means a company can charge well above what it costs to produce or deliver its product, a sign of pricing power, brand strength, or a lack of close substitutes. A thin gross margin often signals a commoditized product where customers can easily switch to a cheaper alternative, forcing the company to compete mostly on price.

Watching gross margin move over time is often more informative than the level itself — expanding margins can signal growing pricing power or efficiency gains; compressing margins can flag rising input costs or discounting to defend market share.

Why it varies so much by industry

Comparing gross margins across industries is close to meaningless. A software company can post gross margins in the 70s or 80s because the marginal cost of serving one more customer is low once the product is built. A grocery retailer might run in the 20s or lower because it's moving physical goods through thin markups at high volume.

A heavy manufacturer sits somewhere in between, weighed down by materials and factory costs. The useful comparison is a company against its direct peers and against its own history, not against a name from a completely different sector.

Reading gross margin alongside the rest of the picture

Gross margin alone doesn't tell you whether a company is actually profitable — that's what operating margin and net margin are for, since a business can have an excellent gross margin and still lose money if operating expenses run too hot.

What gross margin does well is isolate the health of the core product economics, before management's spending decisions enter the picture. A steady or expanding gross margin over multiple years, even in a highly competitive category, is usually a sign a company has carved out some form of durable differentiation rather than competing purely on price.