Gross Margin: Formula, Examples, and How to Improve It

By Newtown Analytics · October 21, 2026 · 8 min read

For smb owners & operators

Gross margin is the share of revenue that remains after paying the direct costs of making or delivering what you sold, and it is the first measure of whether a business model can work at all. A company whose gross margin is too thin cannot cover its overhead no matter how many units it sells, and a company whose gross margin is fat but unmanaged tends to give it away through discounts, freight, returns and write-offs. This guide gives the formula, explains what belongs in cost of goods sold for different types of business, works through examples on price, cost and mix, lists twelve ways to improve it, and shows how to avoid the usual mistakes. It belongs to unit economics and budgeting and forecasting, builds on how to reduce CAC and gross margin vs. contribution margin, and leads to gross margin vs. markup and net profit margin.

The formula

Gross profit = Revenue - Cost of goods sold (COGS)
Gross margin % = Gross profit / Revenue

Example: revenue of $2,000,000 and COGS of $1,300,000 give gross profit of $700,000 and a gross margin of 700,000 / 2,000,000 = 35%.

Gross profit is a dollar amount. Gross margin is a percentage. Both matter, because a business can raise its percentage by selling fewer, higher-margin units while its dollar profit falls.

What belongs in COGS

COGS should include the costs directly tied to producing or delivering the goods or services sold. The exact list depends on the business model and on accounting policy.

Business type	Typical COGS	Often placed elsewhere
Manufacturer	Materials, direct labor, factory overhead, inbound freight, duties	Outbound freight, sales commissions
Distributor or retailer	Purchase cost of goods, inbound freight, duties, sometimes warehouse costs	Outbound shipping, payment fees, returns processing
Ecommerce brand	Product cost, inbound freight, sometimes fulfillment and packaging	Outbound shipping, payment fees, marketing
Software as a service	Hosting, third-party software, support, customer success	Sales and marketing, product development
Services firm	Delivery staff and contractors	Sales, administration
Restaurant	Food and beverage cost, sometimes kitchen labor	Rent, front-of-house labor

Because definitions vary, compare gross margins across companies only after checking what each includes. Within your own company, be consistent from period to period. For decisions, you will often need contribution margin as well. See gross margin vs. contribution margin.

Three examples

A product company

Revenue $2,000,000; COGS $1,300,000 (materials $800,000, direct labor $300,000, factory overhead $150,000, inbound freight $50,000). Gross profit $700,000, gross margin 35 percent.

A service company

Revenue $1,500,000; delivery staff and contractors $900,000. Gross profit $600,000, gross margin 40 percent.

A software company

Revenue $5,000,000; hosting $400,000, third-party tools $250,000, customer support and success $600,000. COGS = $1,250,000. Gross profit $3,750,000, gross margin 75 percent.

The three are different models. A margin of 35 percent is typical for some product categories and a warning sign in software. Judge a margin against the economics of your own model, including the overhead it must cover.

Price, cost and mix: three ways the margin moves

Return to the product company with revenue of $2,000,000 and COGS of $1,300,000.

Price. A 3 percent price increase with no loss of volume raises revenue to $2,060,000. COGS stays at $1,300,000. Gross profit rises to $760,000 and gross margin to 760,000 / 2,060,000 = 36.9%. Dollar gross profit rises by $60,000, or 8.6 percent.

Cost. A 3 percent cut in COGS, to $1,261,000, leaves revenue at $2,000,000. Gross profit rises to $739,000 and gross margin to 36.95%. Dollar gross profit rises by $39,000, or 5.6 percent.

A 3 percent price increase is worth more than a 3 percent cost reduction (by $21,000 here) because price falls entirely to profit, while the cost saving applies only to a part of revenue. This is why the pricing discipline in pricing strategy is so powerful, provided volume holds.

Mix. Suppose the company sells two products: Product A with $1,200,000 of revenue and a 30 percent gross margin, and Product B with $800,000 of revenue and a 45 percent margin.

Gross profit = 0.30 × 1,200,000 + 0.45 × 800,000 = 360,000 + 360,000 = $720,000
Gross margin = 720,000 / 2,000,000 = 36%

If a shift in promotion and shelf space moves $200,000 of revenue from A to B, A falls to $1,000,000 and B rises to $1,000,000.

Gross profit = 0.30 × 1,000,000 + 0.45 × 1,000,000 = 300,000 + 450,000 = $750,000
Gross margin = 750,000 / 2,000,000 = 37.5%

A mix shift of 10 percent of revenue, with no price or cost change, adds $30,000 of gross profit and 1.5 points of margin. See product mix analysis.

Twelve ways to improve gross margin

Lever	What to do
1. Raise prices selectively	Start with products where customers are least price sensitive. See how to raise prices
2. Reduce discounting	Set rules for who may discount, how much, and when. See how discounts erode margin
3. Renegotiate supplier prices	Use volume, term and forecasts as leverage
4. Improve landed cost	Consolidate freight, review incoterms, duties and routing. See landed cost
5. Redesign or respecify products	Simplify materials, packaging and parts
6. Shift the mix	Feature higher-margin products and bundle slow ones with strong ones
7. Reduce waste and scrap	Improve yield, quality control and handling
8. Reduce returns and damage	Address root causes by product
9. Improve labor productivity	Layout, automation and scheduling
10. Reduce shrink and obsolescence	Better forecasting and inventory control
11. Rationalize SKUs	Drop products that do not earn their place. See SKU profitability analysis
12. Update standard costs	Make sure product costs reflect current prices, so decisions use real margins

Leaks that reduce margin quietly

Most gross margin problems are not dramatic. They are leaks:

Discounts and promotions that are broader or deeper than planned.
Freight surcharges and expedited shipping caused by late replenishment.
Inventory write-downs for excess, expired or obsolete stock, which reduce gross profit when they are recognized.
Outdated standard costs that hide supplier price increases until the period ends.
Returns and allowances recorded as revenue reductions or in operating expenses.
Shrink from theft, damage and counting errors.
Mix drift, as lower-margin items grow faster than higher-margin ones.

A monthly gross margin bridge, which breaks the change in margin from last period into price, cost, mix and one-off items, finds these quickly.

A simple margin bridge

Suppose last month's gross margin was 36.0 percent and this month's is 34.5 percent on revenue of $500,000. A bridge might show: price and discount effect -0.8 points, supplier cost increases -0.5 points, mix -0.4 points, inventory write-down -0.6 points, freight +0.3 points, other +0.0. The sum is -1.5 points, which matches 34.5 - 36.0. On $500,000, 1.5 points is $7,500 a month. With the causes identified, management can respond to each, rather than debating the total.

Operations and gross margin

Gross margin is partly a supply chain outcome. Excess inventory leads to markdowns and write-downs, stockouts lead to lost sales and substitute products at lower margins, and poor forecasts lead to expedited freight. Companies that improve forecast accuracy and inventory policy protect margin without raising prices. See demand planning and inventory optimization.

Common mistakes

Comparing margins across companies with different COGS definitions.
Confusing gross margin with markup. See gross margin vs. markup.
Looking only at the percentage and ignoring dollars.
Using standard costs that are out of date.
Leaving freight, returns and fees out of product margin when making decisions.
Averaging across products and missing losers.
Cutting quality to raise margin and losing repeat customers.

How much gross margin do you need?

A target margin should come from the cost structure, not from habit. Work backwards from the profit you want. Suppose a company with $2,000,000 of revenue has fixed operating expenses of $600,000, variable operating costs outside COGS (outbound shipping, payment fees, commissions) of $200,000, and a target operating profit of 8 percent of revenue, or $160,000.

Required gross profit = 600,000 + 200,000 + 160,000 = $960,000. Required gross margin = 960,000 / 2,000,000 = 48%.

If the actual gross margin is 35 percent, the gap is 13 points, or 0.13 × 2,000,000 = $260,000 a year. That gap is the size of the problem, and it can be addressed through price, cost, mix and volume. Spreading the same fixed cost over more revenue also helps: at $2,500,000 of revenue with unchanged fixed costs and variable operating costs at the same percentage, the required margin falls. This calculation turns a vague wish for better margins into a target that can be assigned and tracked. See break-even analysis.

Look beyond the average

The company-wide margin is an average of products, customers and channels with very different margins. The same company might have a top quartile of products with margins above 50 percent and a bottom quartile at 15 percent or less. A margin report by product, customer and channel, ranked from highest to lowest, is the quickest way to find where to act. See product margin analysis and customer profitability analysis.

Reporting cadence

Report gross margin monthly, with the bridge from the prior month and from the same month last year. Show the percentage and the dollars, by product group. Flag any product whose margin has fallen by more than a set threshold, such as two points. Review standard costs at least once a quarter, and whenever a supplier price changes. Margin reporting is only as good as the costs behind it.

FAQs

What is gross margin?

The percentage of revenue left after subtracting cost of goods sold. It is gross profit divided by revenue.

How do you calculate gross margin?

Subtract COGS from revenue to get gross profit, then divide gross profit by revenue.

What is a good gross margin?

It depends on your industry and the overhead you need to cover. A good margin is one high enough to pay for overhead, marketing and growth with profit left over.

What is the difference between gross margin and gross profit?

Gross profit is a dollar amount (revenue minus COGS). Gross margin is that amount as a percentage of revenue.

How can I improve gross margin quickly?

Review discounting, update product costs, renegotiate with suppliers, look at freight and returns, and feature higher-margin products.

This article is for general information. It is not accounting, tax, legal or investment advice, and examples use illustrative numbers rather than client data. Confirm decisions that carry financial or legal consequences with a qualified professional.