Gross margin: what it costs to deliver
Gross margin is the share of revenue left after the direct cost of delivering the product or service. The formula is simple: (Revenue minus Cost of Goods Sold) divided by Revenue.
For a product business, COGS is the cost of materials, manufacturing, and direct labour to make the product. For a service business, COGS is the time of the people delivering the work, plus any direct subcontractor or tool cost.
A worked example
A consultancy bills 10,000 for a project. The senior consultant on the project costs 4,000 in salary time. A subcontracted designer is 1,500. There are no other direct costs.
- Revenue: 10,000
- COGS (consultant + designer): 5,500
- Gross profit: 4,500
- Gross margin: 45%
Net profit: what is actually left
Net profit takes gross profit and subtracts all the indirect costs of running the business — rent, software, marketing, admin staff, your own salary if you are not in the COGS line, taxes.
Continuing the example: if the consultancy spends 30,000 a month on operating costs and bills 80,000 a month at 45 percent gross margin, gross profit is 36,000 and net profit is 6,000 (7.5 percent net margin).
Why the difference matters
Gross margin tells you whether the work itself is profitable. Net margin tells you whether the business is profitable. A 60 percent gross margin business with bloated overheads can still lose money. A 25 percent gross margin business with tight overheads can still print cash.
When you are deciding whether to take on a new line of work, look at gross margin. When you are deciding whether to grow, hire, or cut, look at net margin.
The numbers people get wrong
Three mistakes show up in most small business P&Ls. First, putting their own time in the wrong line — owner-operators often forget to include their own labour in COGS, which inflates gross margin. Second, capitalising costs that should be expenses, or vice versa. Third, mixing personal and business expenses in operating costs, which makes net profit meaningless.