Gross Margin: The Right Place to Start Improving Profitability
Most business owners look at revenue and net income to understand how the business is doing. Both matter. But neither one tells you where to start if you want to improve. Revenue shows you how much business you did. It doesn't tell you whether it was worth doing. Net income shows you what's left, but not where to look to change it.
In our experience, for most small businesses trying to get better, gross margin is the right place to start. It sits upstream of everything else on the P&L and it's usually where the answers are.
One caveat first. If cash is the immediate problem, start there. When payroll is tight, getting visibility on how cash will play out and tightening your receivables and payables comes first. That kind of cash flow management is accounting-side work and does not require a CFO. But cash problems that keep coming back usually trace to something further upstream, and more often than not that something is gross margin.
Greg Crabtree argues in his Simple Numbers books that gross margin is your true top line, and that owners should stop evaluating the business on revenue. We agree. Growing revenue without growing gross profit dollars is just more work.
A note on who this is for. We work with profit-focused businesses, not venture-backed companies spending investor money on growth through their Series B and beyond. Those companies are playing a different game with someone else's money, and margin matters less to them while they do. For an owner funding growth out of the business itself, margin is what pays for that growth. The stronger it is, the more you can reinvest.
“So what is a good gross margin? The answer may not be what you expect.”
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.
“A good gross margin is one you keep beating. Measure it right, beat last quarter, and do it again.”
Do that for a year and a move from 38% to 41% is a real win, whatever the average says. Keep doing it and you pass the businesses that settled for the benchmark.
How to improve gross margin
The goal is the one we just landed on. Keep beating your own gross margin, quarter after quarter. This section is how you do it.
Two things have to be in place first. The margin has to be measured correctly, or you're improving a number that isn't real. And you have to give up the most common instinct for fixing margin, which is selling more of the same thing at the same margin. You cannot sell your way out of a margin problem.
Here's why. Every sale at a bad margin imports the problem at scale. More revenue means more delivery cost, more working capital tied up, and more overhead to support it all, funding a margin that was never enough in the first place. Growth doesn't dilute a margin problem. It multiplies it. Bad margins plus volume is how companies grow themselves out of business.
If you want to see this for yourself, tools like Fathom's Goalseek make it visual. Set a profit target and the model shows you what has to change to hit it. At a weak margin, the revenue required is usually implausible. A small margin improvement gets you there at volume you already have. We've written about Goalseek before because few tools make this argument as clearly.
So work the margin directly. Here are the levers, roughly in order of impact.
Pricing. The biggest lever and the most avoided. A price increase flows almost entirely to gross profit because it adds no delivery cost. Most owners would rather chase volume than raise prices. Chasing volume feels safer, but it's usually just avoiding the harder decision. If you haven't raised prices in two years, start here.
Discounting. The flip side of pricing and a quiet profit eater. Every dollar you discount comes straight off gross profit. Nothing about delivery got cheaper, so the whole discount is margin you handed away. The effect on the bottom line is bigger than it looks. If your net margin is 10% and you discount a deal by 5%, you didn't give up 5% of the profit on it. You gave up half. Discounts get handed out at the point of sale by people under pressure to close, which is why the fix is sales training, not a policy memo. A team that understands what a discount does to gross margin and net profit holds price more often, and that shows up directly in your numbers.
Cost of delivery. Vendor terms, hosting costs, freight rates, fulfillment contracts. These compound quietly because nobody renegotiates them until forced. Lowering delivery cost, whether through better terms or a lower cost delivery model, buys you one of two things. Higher margin at current prices, or room to price more competitively. Both are legitimate. The mistake is not choosing. Decide which one you're taking and hold to it.
Utilization. For services firms, the gap between what you pay your delivery team and what you bill for their time is often the biggest leak. Bench time and non-billable hours are cost with no revenue attached. Lifting utilization even a few points moves margin directly.
Scope creep. A separate problem that hits the same line. The work grows, the cost lands in your direct costs, and no extra invoice goes out. It hides inside projects that look fine in total, so it's easy to miss. Tracking profitability at the project level is how you catch it. A tool like WorkflowMax shows which jobs and which people actually make money, so both weak utilization and quiet scope creep surface before they cost you a quarter.
Mix. Not everything you sell carries the same margin. Know which offerings earn more and steer the business toward them. This doesn't require an elaborate dashboard. It requires looking at what you sell, understanding which work is actually worth doing, and saying yes more often to the good kind.
Where your accounting team fits
Two things have to come from your accounting function for any of this to work.
The first is numbers you can trust. Accurate gross margin requires accrual books, consistent treatment of direct costs and sensible allocations applied every single month. That's disciplined accounting work, done on time, the same way, month after month. When it's in place, your margin trend becomes the most useful line on your financials. When it's not, every conversation about margin is a conversation about a number nobody believes.
The second is a team that helps you act on them. Clean books that nobody reads don't improve anything. The work we're describing in this post, watching the margin trend, flagging when it slips, bringing the levers to you, is accounting-side work too. You don't have to go up the chain to a CFO to get it. This is what management accounting is. It's the difference between books that get closed and books that tell you how to run the business.
In closing
There's a real difference in how these two businesses feel to own. A business with a weak gross margin is always tight. Every new client is a relief that doesn't last. There's never quite enough to hire the person you need or invest in the thing that would help. You're working hard and the business stays fragile.
A business with a strong gross margin has room. The same revenue throws off more cash. You can pay people well, absorb a slow month, and fund the next move without borrowing against hope. That room is what margin buys you. It's the difference between running the business and the business running you.
That's the reward, and it's why this is the first thing to get under control. You don't get there in one move. You get there one lever at a time, quarter after quarter, watching the line climb. Measure it right, beat last quarter, and start this month.
Frequently Asked Questions
What is a good gross margin for a small business? It depends on the industry. Software companies typically run 70% to 85%, professional services firms 40% to 60% blended, and ecommerce businesses 30% to 60% depending heavily on category and sales channel. Your own trend matters more than any benchmark. A correctly measured margin that improves quarter over quarter is the real target.
Is gross margin the same as gross profit? No. Gross profit is a dollar amount, revenue minus your direct costs (COGS). Gross margin is that amount expressed as a percentage of revenue. The dollars pay your bills. The percentage is what you benchmark and trend over time.
Are direct costs, COGS, and cost of sales the same thing? For gross margin, treat them as the same. Direct costs, cost of goods sold (COGS) and cost of sales (COS) all describe the cost of delivering what you sell. COGS is the common term for businesses selling physical products. Cost of sales shows up more often in services and software. We use direct costs in this post because it describes the number most plainly, but the math is identical whichever label your books use.
Should payroll be included in direct costs (COGS)? Only the payroll directly tied to delivering your product or service. Delivery team wages in a services firm and support or implementation labor in a software company belong in direct costs. Admin, sales and management payroll do not. People who split time should be allocated consistently.
Do merchant service fees belong in direct costs (COGS)? No. Payment processing is a cost of selling, not a cost of what you sold. It belongs below gross profit with other variable selling costs. Including it understates your gross margin and makes benchmarking unreliable.
How often should I review gross margin? Monthly, as part of reviewing your financial statements. Gross margin moves slowly, so the monthly review is less about reacting to a single month and more about watching the trend and catching erosion early.
