Understanding gross margin versus net margin

From: alexhormozi

Many small to medium-sized business owners struggle with cash flow despite working hard, often finding too little money in their bank accounts at the end of the month [00:00:00]. This common issue stems from a lack of adequate understanding of the difference between gross and net margin [00:00:14]. Understanding margin is crucial for assessing a business’s health and potential for investment [00:00:32].

Gross Margin

Gross margin represents the direct cost of fulfilling goods or services [00:00:53]. It is calculated as: Revenue - Cost of Goods Sold (COGS) [00:01:11]

For a service business, COGS refers to the incremental cost of providing an additional unit of service [00:01:32]. This excludes overhead costs such as front desk staff, HR directors, or rent [00:01:36]. For service businesses, COGS often relates to payroll hours for those directly delivering the service [00:01:24].

Gross Margin Calculation Example

Consider a service sold for $60 p er h o u r, w i t ha d i rec t cos t o f$ 20 per hour (e.g., paying a service provider) [00:02:22].

Revenue: $60 [00:02:30]
Cost of Goods Sold (COGS): $20 [00:02:33]
Gross Profit: $60 (R e v e n u e) -$ 20 (COGS) = $40 [00:02:40]
Gross Margin Percentage: ( $40/$ 60) * 100% = 66% [00:03:05]

Net Margin

Net margin represents the “juice” or what is left over at the end of the month after all expenses are paid [00:01:51]. This is the amount a business owner takes home [00:01:59].

The gross margin is considered foundational because it “begets” or creates the net margin [00:02:07]. Optimizing gross margin is often the primary focus for improving a business’s profitability [00:02:10].

Importance of High Gross Margin

Even small changes in gross margin can have a significant impact on business growth and net profit.

For example, a business with a 66% gross margin might only achieve 12% net margins at the end of the year (typical for many brick-and-mortar businesses) [00:03:30]. By bumping the gross margin to 80%, the net margin could increase to 26%, more than doubling the business’s earnings (2.2x increase) [00:03:47].

A general rule of thumb for service-based businesses is to target a gross margin of over 80% [00:04:21].

Why 80%+ Gross Margin?

A high gross margin is crucial because the remaining profit after COGS must cover:

Marketing and customer acquisition costs [00:06:05]
Rent and other facility costs [00:08:19]
Payroll for non-essential staff (e.g., administrative, HR) [00:08:23]
Software and other operational costs [00:08:25]
Ultimately, the desired net profit [00:06:11]

Without sufficient gross margin, a business cannot scale or achieve significant profitability [00:07:34]. Successful businesses, especially the largest ones, often operate with 99% gross margins [00:06:16].

The “Magic” of Incremental Gross Margin Increases

The difference between, for example, 80% and 90% gross margins is not just 10 percentage points; it’s a doubling of profitability [00:06:48]. This is because moving from 80% to 90% gross margin means the cost of goods sold is halved (e.g., from $20 t o$ 10 on a $100 service) [00:06:54].

This means a business can acquire twice as many customers for the same cost, enabling enormous scaling and profit [00:07:09]. This is why entrepreneurs must overcome any mental barriers about charging more for services or products that don’t have high direct costs [00:07:22].

Methods to Increase Gross Margin

There are two primary ways to increase gross margin percentage:

Decrease the Cost of Goods Sold (COGS): For a $60 ser v i ce w i t han or i g ina l$ 20 COGS (66% gross margin), decreasing COGS to $12 w o u l d res u lt ina$ 48 gross profit. This leads to an 80% gross margin ( $48/$ 60) [00:04:40].
Increase the Price: If COGS remains at $20, t o a c hi e v e an 80$ 100 ( $80 g ross p ro f i t o na$ 100 service, which is 80%) [00:05:12]. This relates to the concept of arbitrage and price differences and selling to wealthy customers vs mass markets.

Service Business Example: Coaching Industry

Consider a coaching business:

A coach is paid $4,000 per month [00:10:09].
This coach can handle 40 clients [00:10:17].
Clients purchase packages for $1, 200, w hi c h co v ers t h ree m o n t h so f ser v i ce < a c l a ss = " y t - t im es t am p " d a t a - t = "00 : 10 : 26" > [00 : 10 : 26] < / a >, e q u a t in g t o$ 400 per client per month [00:10:39].

Let’s calculate the gross margin for this scenario:

Total Revenue per Coach: 40 clients * $400/ m o n t h / c l i e n t =$ 16,000 per month [00:10:50].
Cost of Goods Sold (COGS): The coach’s salary, $4,000 per month [00:11:14].
Gross Profit: $16, 000 (R e v e n u e) -$ 4,000 (COGS) = $12,000 [00:11:20].
Gross Margin Percentage: ( $12, 000/$ 16,000) * 100% = 75% [00:11:28].

Even though 75% is close to the 80% target, increasing it by just 5 percentage points (from 75% to 80% gross margin) can lead to a 25% increase in net profit at the end of the year [00:11:51].

To reach an 80% gross margin with the current COGS of $4, 000, t h ere v e n u e w o u l d n ee d t o b e$ 20,000 ( $4, 000 b e in g 20$ 20,000). This means the coaching business would need to charge each of its 40 clients an extra $100 p er m o n t h (40 *$ 100 = $4, 000 a dd i t i o na l re v e n u e n ee d e d, makin g t h e n e wp erc l i e n t c ha r g e$ 500/month), or reduce the coach’s salary to $3,200 [00:12:42].

This demonstrates the critical nature of understanding and optimizing gross margin for overall business profitability and growth.

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