Gross margin: the percentage that decides what the business can afford

Gross margin is what is left of revenue after the direct cost of what you sold, expressed as a percentage of revenue. Sell for 100, with a direct cost of 60, and the gross margin is 40%. That percentage is the single most useful number in a small business, because it determines what everything else can cost — the rent, the salaries, the software, and eventually the profit.

It is also the number most frequently miscalculated, through a confusion so common it deserves stating first: margin and markup are different percentages of different things, and using one where you meant the other quietly underprices everything you sell.

Margin against markup

Markup is calculated on cost; margin is calculated on the selling price. Take an item costing 60. A 50% markup means adding half the cost — you sell at 90, and the margin is 33%, because 30 of the 90 is yours. To achieve a 50% margin you would have to sell at 120, which is a 100% markup. The gap widens as the numbers rise, and a business that sets prices by markup while planning by margin is short in exactly that gap, every single sale.

• Margin = (price − cost) ÷ price.
• Markup = (price − cost) ÷ cost.
• 25% markup is a 20% margin. 50% markup is a 33% margin. 100% markup is a 50% margin.
• Pick one and use it everywhere, including in conversations with suppliers, who will usually be talking in the other one.

What belongs in the direct cost

• For a product business: the purchase or manufacture cost, inbound freight, packaging, and payment processing fees.
• For a service business: the labour delivering the work, plus anything bought specifically for the job. If everybody is salaried and nobody is tracked to jobs, the calculation is harder and worth doing anyway.
• Not: rent, marketing, admin salaries, software. Those are fixed costs below the gross margin line, and moving them up flatters nothing.
• Consistently. The comparison between periods is what makes the number useful, and it breaks the moment somebody reclassifies a cost.

Watch the direction of gross margin over time rather than the level. Different trades run at very different margins — grocery at single digits, software near ninety, a builder somewhere between — so an absolute number tells you little without a comparison. A margin falling one point a quarter, however, is a specific problem: suppliers raising prices, discounting creeping in, or a product mix drifting towards the cheaper lines.

Improving it

1. Look at margin per product or per job, not just in aggregate. Almost every business has a line it sells enthusiastically at a margin it would not accept if it looked.
2. Check discounting. Authorised discounts and small habitual ones are frequently the entire difference between the planned and actual margin.
3. Renegotiate the largest input cost, and be specific: volume, payment terms, a longer commitment in exchange for a lower price.
4. Raise prices on the lines where you have the least competition rather than across the board.
5. Drop or reprice the worst line. This is usually the fastest single improvement and the hardest decision.

Where the number comes from

Ettex Books produces the gross margin from what you record — sales, direct costs and the split between them — and the accuracy depends entirely on that split being consistent. The price side is covered in value-based pricing, the volume question in break even analysis, and the surrounding statement in profit and loss statement.

One limit worth naming: the software cannot decide what counts as a direct cost in your business. That judgement is yours and, once made, matters mostly for being applied the same way every month.