From: alexhormozi
Understanding gross margin is critical for small and medium-sized business owners, especially those in service businesses [00:00:14]. It is considered a primary indicator of a business’s health [00:00:33].
Gross Margin vs. Net Margin
- Gross Margin: Represents the direct cost of fulfilling goods or services [00:00:53]. It’s the revenue minus the cost of goods sold (COGS) [00:01:11].
- Net Margin: This is the “juice” at the end of the month—what’s left over after everything is paid, representing the final profit taken home [00:01:55].
- Gross margin “begets” or creates the net margin, making it a key area of focus for business improvement [00:02:08].
Calculating Gross Margin for Service Businesses
The formula for gross margin is straightforward subtraction:
Gross Margin = Revenue - Cost of Goods Sold (COGS) [00:01:11]
For a service business, the “cost of goods sold” (COGS) is different from a product-based business [00:01:17]. It refers to the incremental cost of providing one additional unit of service [00:01:32]. This does not include:
- Front desk roles [00:01:37]
- HR directors [00:01:39]
- Rent [00:01:40]
- Non-essential payroll [00:08:23]
- Software costs [00:08:25] These are considered overhead costs that come out of the remaining gross margin before calculating net margin [00:08:27].
To express gross margin as a percentage:
Gross Margin Percentage = (Gross Margin / Revenue) * 100 [00:03:07]
Example 1: Hair Stylist or Trainer
- Service Price (Revenue): $60 per hour [00:02:22]
- Cost of Goods Sold (COGS): $20 (what you pay the person performing the service) [00:02:33]
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Calculate Gross Margin (dollars): $60 (Revenue) - $20 (COGS) = $40 [00:02:40]
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Calculate Gross Margin Percentage: ($40 / $60) * 100 = 66% [00:03:13]
The 80% Rule of Thumb
For any service-based business, a target gross margin of 80% or higher is ideal [00:04:21].
- Moving from 66% gross margin to 80% can significantly increase net margins. For instance, if a business typically runs 12% net margins at 66% gross margin, achieving 80% gross margin could lead to 26% net margins, more than doubling profit [00:03:35].
- Increments in gross margin (e.g., from 80% to 90%, or 90% to 95%) can double the profitability of a business because they mean halving the direct costs [00:06:48]. This allows for serving twice as many people for the same cost [00:07:09].
Example 2: Coaching Business
A coaching business pays a coach $4,000 per month [00:10:09]. This coach can handle 40 clients [00:10:21]. Clients pay $1,200 for a three-month package, which equates to $400 per month [00:10:30].
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Calculate Total Monthly Revenue: 40 clients * $400/month = $16,000 [00:10:50]
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Identify Cost of Goods Sold (COGS): The coach’s salary, as they directly fulfill the service for clients: $4,000 [00:11:16]
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Calculate Gross Margin (dollars): $16,000 (Revenue) - $4,000 (COGS) = $12,000 [00:11:20]
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Calculate Gross Margin Percentage: ($12,000 / $16,000) * 100 = 75% [00:11:31]
Why Optimizing Gross Margin Matters
Even a small increase in gross margin percentage can lead to significant increases in net margin and overall profitability [00:11:56]. For example, moving from 75% to 80% gross margin can increase net margins by 25% [00:12:01].
The two main methods to increase gross margin are:
- Decrease the direct cost of fulfilling the service [00:05:04], e.g., by paying the coach less [00:13:04].
- Increase the price charged for the service [00:05:12], e.g., by charging clients more per month [00:12:54].
Higher gross margins allow a business to:
- Cover all other operating expenses (rent, payroll, marketing, software, etc.) [00:06:03]
- Invest in marketing to acquire more customers [00:06:05]
- Achieve substantial profit [00:06:11]
- Enable significant scaling [00:07:14]
This impact of margin optimization on business growth highlights the importance of overcoming any “mental barrier” about charging appropriate prices for services, especially when the direct cost of delivery is low [00:07:30]. Without adequate gross margin, a business will struggle to generate profit and scale to help more people [00:07:32].