Gross margin is what fraction of each dollar of revenue survives the direct cost of delivering it. Subtract the cost of goods sold — materials, manufacturing, the servers a software product runs on — from revenue, and express what is left as a percentage. A gross margin of 60% means sixty cents of every dollar is available to pay for research, sales, administration, interest, tax and, eventually, the owners.
It is the cleanest quantitative signal of pricing power. A company that can charge well above what a unit costs it to produce is being allowed to by its customers and its competitors, and that permission is the thing a competitive advantage actually consists of.
Not to be confused with markup, which divides the same gross profit by the cost rather than by the revenue: a 50% margin is a 100% markup. Note also that the change in a margin is measured in percentage points — from 60% to 63% is three points, not a 3% rise.
A company with $800m of revenue and $320m of cost of goods sold:
Suppose costs rise to $360m on the same revenue. Gross margin falls to 55% — five percentage points — and $40m disappears from the bottom line, because nothing below this line got any cheaper. On a business whose net margin was 10%, that is half the profit, from a change most readers would call small.
Watch the direction more than the level. The level is mostly a fact about the industry — software runs high, distribution and grocery run low, and neither says anything about management. The trend is a fact about the company: a margin drifting down over several years is competition, input costs or discounting, and it usually shows up here before it shows up anywhere else.
Compare only within an industry, and beware the accounting. What sits in cost of goods sold versus operating expenses is not uniform between companies, so two apparently different margins can be the same business with different policies.
In the app, gross margin is one of the twenty-one key metrics on a company page, with the change against the same period a year earlier beside it in percentage points.
It matters most when inflation is moving input costs, when a company is growing quickly — a scaling business should be able to show the margin holding or rising, and a falling one suggests growth is being bought with discounts — and on any company whose case rests on a moat. It is also the first line to check when profit falls: if the gross margin held, the problem is below it and more easily fixed.
It ignores everything below the gross line, and plenty of companies with enviable gross margins lose money after sales and research are paid for. It is not comparable across industries at all, and barely comparable across companies that classify costs differently. For a bank, an insurer or an asset-light service business the concept may not be reported in a meaningful form, and a margin can also be propped up temporarily by deferring maintenance or running down inventory bought at old prices.