Working on gross margin is one of the ways we help businesses get more profitable. It falls under the Performance focus of our P-R-O-F-I-T Approach™, in a playbook we call Be More Profitable. It isn’t the whole of that work. There are other areas to improve financial performance. But it’s a strong place to start, and if you don’t know where to begin, this is where we’d point you.
What gross margin really tells you
Gross margin is what’s left after the direct cost of delivering what you sell. Not rent. Not the sales team. Not your accounting fees. Just the costs that exist because you delivered a product or service to a customer.
It answers one question. Does your core offering make enough to cover everything else and still leave room to grow? Almost every business has a positive gross margin. The point isn’t whether the number is positive. It’s whether it’s high enough. A core offering that barely covers its own delivery costs can’t carry your overhead, much less fund growth.
Before going further, two terms need separating because most non-accountants use them interchangeably. Gross profit is a dollar amount. It’s revenue minus direct costs. Gross margin is that same number expressed as a percentage of revenue. A company that sells $5M and spends $3M delivering it has $2M of gross profit and a 40% gross margin.
Both matter and they do different jobs. Gross profit dollars are what you actually spend. They cover overhead, fund growth and eventually become net income. Gross margin is what you benchmark, trend and compare, because dollars can grow while the business quietly gets less efficient. A company can post record gross profit while its margin erodes year after year. The dollars hide it. The percentage catches it.
We’ll use each term where it fits for the rest of this post. Just know they’re related but not the same.
Gross margin is not just a subtotal on the P&L. It’s the best measure you have of whether your business model works.
Does gross margin actually matter, or is net income enough?
Some accountants will tell you gross margin is just real estate on the P&L. Move a cost above the line or below it and net income doesn’t change a dollar. Taxes don’t change. From a compliance perspective that’s completely true. The IRS doesn’t care where your hosting costs sit.
But your financials have two jobs and compliance is only one of them. The other is management. A compliance P&L exists to compute the bottom line. A management P&L exists to explain it. Gross margin is the line that does the explaining.
Consider two companies. Both do $8M in revenue. Both net $400K. On the bottom line they’re identical.
The first runs a 55% gross margin with heavy overhead. Its core business works. The problem is everything below the line, and overhead problems are fixable. You can cut, renegotiate and restructure your way out of them.
The second runs a 28% gross margin with lean overhead. There’s nothing left to cut. The problem is the business itself. Pricing is too low, delivery costs too much, or both. That’s a much harder fix and it gets harder the longer it hides.
Net income can’t tell these two companies apart. Gross margin can. That’s the difference between a number that reports and a number that diagnoses.
There’s a second reason it matters. Gross margin determines whether growth helps you. A strong margin means every new dollar of revenue strengthens the business. A weak margin means growth just scales the problem. We’ll come back to that.
If you want the broader picture of building profit into your business, we’ve written about that in How to Build a More Profitable Business. This post stays focused on the margin itself.
How to calculate gross margin correctly
The formula is simple. Revenue minus your direct costs, divided by revenue. Direct costs are what it takes to deliver what you sell. You’ll also see them called cost of goods sold (COGS) or cost of sales (COS). We use direct costs through the rest of this post. The hard part isn’t the math. It’s getting honest numbers into it.
Accrual books. On cash basis books, gross margin is close to meaningless. Revenue lands when customers pay. Costs land when you pay vendors. The two rarely land in the same month, so your margin swings wildly and tells you nothing about the business. One month shows 70%, the next shows 20%, and neither is real. Accrual accounting matches revenue and cost to the period they belong to, which is the entire point of measuring margin. We’ve written about the accruals that separate mature businesses if you want the deeper version.
Direct costs. Your direct costs are what it takes to deliver what you sold. What they include depends on the business.
For a software company, direct costs typically include hosting and infrastructure, third party tools embedded in the product, and the labor that supports or implements it for customers. Developers building new features usually sit below the line in R&D.
For a professional services firm, direct costs are mostly people. Delivery team payroll and contractors who do client work. The judgment call is the people who split time, like a manager who delivers some weeks and sells others. More on that below.
For an ecommerce business, direct costs include product cost, inbound freight, packaging and fulfillment. The cost of getting product to your warehouse counts. Note the direction on freight. Inbound freight is part of acquiring your inventory, so it belongs in direct costs. Outbound shipping to customers is a cost of selling, which is a different thing. If you sell on Amazon, the fee stack splits the same way. FBA fulfillment and storage fees are fulfillment, so they go in direct costs. The referral fee is a cut of the sale, like a merchant fee, so it sits below gross margin as a selling cost.
Common mistakes. We’ve flagged a couple already, like outbound shipping and the Amazon referral fee. Here are the ones we see land in direct costs most often and shouldn’t. Merchant service fees top the list. Payment processing is a cost of selling, not a cost of what you sold. The same goes for outbound shipping and for marketing. These are real variable costs and they matter, but they belong in a different cut of the numbers called contribution margin. That’s a topic for another post. For now, keep them out of direct costs so your gross margin means what it’s supposed to mean.
Allocations. When someone splits time between delivery and admin, the traditional approach allocates part of their cost into direct costs. A services firm where the owner delivers half the time would put half that salary in direct costs. Skip it entirely and your gross margin is overstated, and you don’t know by how much.
Worth a note here. Greg Crabtree’s Simple Numbers takes a different path. Rather than allocating split labor into direct costs, it pulls labor out and measures it on its own with the Labor Efficiency Ratio, gross margin divided by labor. The direct labor version, dLER, goes beyond the traditional gross margin view. It’s a useful model and worth reading. We’re using the traditional approach in this post.
One honest point either way. Allocations move cost between sections of the P&L. They don’t remove it. Allocate admin time out of direct costs and gross margin improves while operating expenses absorb exactly what it shed. Net income doesn’t move. If your margin improved only because you changed an allocation, nothing about the business improved. The purpose is accuracy, not a better number. Pick a method, apply it the same way every month, and let the trend do the work.
What is a good gross margin? Benchmarks by industry
With the calculation right, here’s what good looks like in 2026.
Software. Typically runs 70% to 85%. Pure self-serve products sit at the top of that range. Companies with implementation services or heavy support sit lower, and that’s structural rather than a failure. One observation worth making. A bootstrapped software company should care about this number in a way a funded one often doesn’t, because for a bootstrapped company the margin is the entire engine.
Professional services. Typically runs 40% to 60% blended, depending on how leveraged the delivery team is. You may have heard the pricing rule of thumb that billable work should be priced at three times loaded cost, which implies a 67% margin. Both numbers are right and they measure different things. The 3x rule is a pricing target on billable hours. The 40% to 60% range is what firms actually land at after bench time, non-billable hours, write-offs and scope creep eat into it. The distance between your pricing math and your blended margin is mostly a utilization story, and knowing both numbers tells you where to look when they diverge.
Ecommerce. Runs the widest range of the three, roughly 30% to 60%, and the channel you sell through drives it as much as the product. Branded direct to consumer brands, usually on Shopify, hold real pricing power and sit at the top, higher still in categories like beauty. Sellers who lean on Amazon sit lower, because marketplace fulfillment and storage fees land in direct costs and the referral fee takes its cut on top. The same product can post a healthy margin on your own store and a thin one on a marketplace.
Two caveats before you measure yourself against any of these. First, benchmarks assume your calculation is right. A 55% margin with merchant fees stuffed into direct costs and no labor allocations isn’t comparable to anything. Second, published ranges blend companies of every size and model. They’re context, not a scoreboard.
So what is a good gross margin? Partly it’s a number near the ranges above. But the ranges are the least useful part of the answer. Published averages blend businesses that aren’t yours, at sizes that aren’t yours, with costs you can’t see. You can match the average and still be sliding. You can sit under it and be in good shape for your model. Measuring yourself against a number you don’t control is a quiet drain. It feels like diligence and it changes nothing.
