From: alexhormozi
Understanding the difference between gross and net margin is crucial for any business owner, especially small and medium-sized enterprises (SMEs) [00:00:17]. Margin represents the money a business makes [00:00:26] and is considered a primary indicator of a business’s health and investment potential [00:00:32]. For businesses that struggle with profitability despite significant effort, focusing on margin can be the key to financial improvement [00:00:07].
Gross Margin vs. Net Margin
The core issue for many businesses is often a lack of adequate grasp on the distinction between gross margin and net margin [00:00:19].
Gross Margin
Gross margin represents the direct cost associated with fulfilling your goods or services [00:00:53]. It is calculated simply as:
Revenue - Cost of Goods Sold (COGS) [00:01:11]
For service-based businesses, which constitute the majority, the Cost of Goods Sold refers to the “incremental cost of the additional unit” [00:01:32]. This means it only includes costs directly tied to delivering an additional service, such as the pay for the service provider, and excludes overheads like front desk staff, HR directors, or rent [00:01:36].
Net Margin
Net margin is the profit left over after all expenses are paid [00:01:59]. It’s the “juice at the end of the month” that business owners actually take home [00:01:55].
The Relationship and Impact of Margin on Profitability
While both are important, gross margin directly influences and creates the net margin [00:02:08]. This makes gross margin a primary focus for business improvement [00:02:10].
Consider a service priced at 20.
- Gross Profit: 20 (COGS) = $40 [00:02:30]
- Gross Margin Percentage: (60) * 100% = 66% [00:03:06]
Most brick-and-mortar businesses operate with a net margin around 12% [00:03:38]. A small increase in gross margin can lead to a disproportionately large increase in net margin. For example, raising the gross margin from 66% to 80% can more than double the net margin, from 12% to 26% [00:03:47]. This highlights the significant impact of margin optimization on business growth [00:04:10].
Target Gross Margin for Service Businesses
A good rule of thumb for service-based businesses is to aim for a gross margin of 80% or higher [00:04:21]. Top businesses in the world often operate with 99% gross margins [00:06:22].
The difference in profitability between various high gross margins is profound:
- Moving from 80% to 90% gross margin means the business is twice as profitable, as the cost is halved [00:06:48].
- Similarly, from 90% to 95% gross margin, the business again doubles in profitability [00:07:03]. This exponential improvement signifies that you can serve “twice as many people for the same cost” [00:07:09].
Strategies to Increase Gross Margin
There are two primary methods to increase gross margin:
- Decrease Direct Costs: Reduce the cost of fulfilling the service or producing the good [00:04:40]. For example, reducing the 12 on a 48, resulting in an 80% gross margin (60) [00:04:47].
- Increase Price: Charge more for the service or product [00:05:12]. To achieve an 80% gross margin with a 100 (20 = 80/$100 = 80%) [00:05:27].
Entrepreneurs often face a “mental barrier” regarding charging higher prices, especially for services with low direct costs [00:07:37]. However, failing to optimize gross margin will result in minimal profit and hinder the ability to scale and help more people [00:07:32].
Role of Leverage and Efficiency in Scaling a Business
High gross margins provide the necessary funds to cover all other business expenses, including marketing to acquire new customers, rent, non-essential payroll, and software [00:06:03]. This surplus is vital for business growth and scalability [00:07:12].
Real-World Example: Coaching Business
Consider a coaching business:
- Coach’s salary: $4,000 per month [00:10:09]
- Coach’s capacity: 40 clients [00:10:18]
- Client package: 400 per month [00:10:30]
Calculation:
- Total Revenue per coach: 40 clients * 16,000 per month [00:10:46]
- Gross Profit: 4,000 (Coach’s Cost) = $12,000 [00:11:12]
- Gross Margin Percentage: (16,000) * 100% = 75% [00:11:28]
Even a seemingly small jump from 75% to 80% gross margin can significantly impact net margin. If a business has 15% net margins, increasing gross margin to 80% could raise net margins to 20% [00:11:48]. This 5% increase in net margin represents a 25% increase in overall profit [00:12:01].
To achieve an 80% gross margin for this coaching example, one would need to:
- Increase revenue to 4,000) [00:05:27], perhaps by charging clients an extra 500/month = $20,000) [00:12:54].
- Or, decrease the coach’s pay to 16,000) [00:13:04].
This demonstrates how a strategic focus on gross margin can lead to substantial improvements in overall business profitability [00:13:07].