Methods to increase gross margin

From: alexhormozi

Many small to medium-sized business owners struggle with profitability due to an inadequate understanding of the difference between gross and net margin [00:00:19]. Margin is fundamentally about money [00:00:26] and is considered the number one indicator of a business’s health and investment potential [00:00:32].

Gross Margin vs. Net Margin

• Gross Margin represents the direct cost of fulfilling goods or services [00:00:53]. It is calculated by subtracting the cost of goods sold (COGS) from revenue [00:01:11].
  • For service businesses, COGS refers to the incremental cost of producing one additional unit of service [00:01:32]. This means it only includes the cost directly tied to delivering that specific service, such as direct labor, and does not include overhead expenses like front desk staff, HR directors, or rent [00:01:36].
• Net Margin is the “juice” at the end of the month [00:01:55]; it’s what remains after all expenses are paid, and what the business owner can take home [00:01:59].

While both margins are important, the gross margin is crucial because it directly creates the net margin [00:02:08]. Focusing on improving gross margin is a primary strategy for fixing a business’s financial health [00:02:10].

The Significance of Gross Margin Percentage

A common scenario might involve a service sold for $60withadirectcostof$20, leaving $40.Thisresultsinagrossmarginof66$40/$60) [00:02:22], [00:02:33], [00:02:40], [00:03:13]. While this might seem acceptable, most brick-and-mortar businesses operating at 66% gross margins typically end the year with only around 12% net margins [00:03:35], [00:03:43].

Even a seemingly small increase in gross margin can have a dramatic effect on net profits. For example, increasing gross margins from 66% to 80% can more than double (2.2x) the net margins, turning 12% into 26% [00:03:47], [00:03:53], [00:04:05], [00:04:08]. The speaker’s rule of thumb is to aim for a gross margin of at least 80% for any service-based business [00:04:21], [00:08:42].

Moving from 80% to 90%, or 90% to 95%, effectively doubles the profitability of the business at each increment because it halves the relative cost [00:06:48], [00:06:55], [00:07:03], [00:09:07]. This allows a business to acquire twice as many customers for the same cost, leading to massive scaling [00:07:09], [00:07:14].

Methods to Increase Gross Margin

There are two primary ways to increase your gross margin percentage:

1. Decrease the Cost of Goods Sold (COGS):

   • By reducing the direct cost of fulfilling the service or product, more revenue remains after production.
   • Example: If a service costs $60toselland$20 to fulfill, but the fulfillment cost is reduced to $12,thenewgrossprofitbecomes$48. This increases the gross margin to 80% ($48/$60) [00:04:40], [00:04:47], [00:04:53], [00:05:00], [00:05:04].

2. Increase the Price:

   • Charging more for the same service or product while maintaining the same COGS will directly increase the gross profit.
   • Example: If the fulfillment cost remains $20,buttheservicepriceisincreasedfrom$60 to $100,thegrossprofitbecomes$80. This also results in an 80% gross margin ($80/$100) [00:05:12], [00:05:16], [00:05:22], [00:05:28], [00:05:30], [00:05:33].

After covering the cost of goods sold, the remaining gross profit must cover all other business expenses, such as marketing to acquire new customers, rent, non-essential payroll, software, and still leave a profit [00:06:00], [00:06:05], [00:06:11], [00:08:17]. Successful businesses, including the largest in the world, often aim for 99% gross margins [00:06:16], [00:06:22]. Entrepreneurs should overcome any “mental barrier” about charging more for services that don’t cost a lot to fulfill [00:07:23], as this is essential for profitability and scaling [00:07:30].

Real-World Example: Coaching Business

Consider a coaching business:

• Coach’s monthly salary (COGS): $4,000 [00:10:09].
• Coach’s capacity: 40 clients [00:10:17], [00:10:21].
• Client package: $1,200forthreemonths,whichbreaksdownto$400 per month per client [00:10:28], [00:10:33], [00:10:39].

Calculation:

• Monthly Revenue: 40 clients * $400/client=$16,000 [00:10:46], [00:10:50], [00:11:07].
• Gross Profit: $16,000(Revenue)-$4,000 (Coach’s Salary) = $12,000 [00:11:14], [00:11:20].
• Gross Margin Percentage: $12,000/$16,000 = 75% [00:11:26], [00:11:32].

Although 75% is close to the 80% target, increasing it to 80% for this business would translate to a 25% increase in net margins at the end of the year (e.g., from 15% net margin to 20% net margin) [00:11:38], [00:11:48], [00:12:01].

To achieve an 80% gross margin in this example, the business could:

• Decrease COGS: Pay the coach $3,200permonthinsteadof$4,000 [00:13:04], [00:13:08].
• Increase Price: Charge each of the 40 clients an extra $20permonth(totaling$420/month per client) [00:12:50], [00:12:54], [00:12:57], [00:13:00].

Optimizing gross margin is a fundamental strategy for increasing earning capacity and business value [00:13:24].