Gross Margin: The Profitability Metric That Reveals Your Business Model

The 30-Second Definition

Gross Margin

Gross margin measures the percentage of revenue remaining after deducting the direct costs of producing or delivering a product or service. It is calculated by subtracting cost of sales from revenue, dividing the result by revenue, and expressing the answer as a percentage.

For example, a business generating £3 million of revenue with direct costs of £900,000 produces a gross profit of £2.1 million and a gross margin of 70%.

While EBITDA is the headline measure used to value businesses, gross margin explains how that profitability is created. It reveals the underlying economics of the business model, the level of pricing power the company possesses, and how efficiently revenue is converted into profit before operating overheads are considered.

During due diligence, buyers analyse gross margin alongside Adjusted EBITDA to determine whether reported earnings are sustainable and whether future growth is likely to improve profitability or simply generate additional workload.

Why Gross Margin Matters More Than EBITDA Alone

Adjusted EBITDA determines the valuation multiple. Gross margin helps determine whether that EBITDA deserves the multiple.

Two businesses can report identical EBITDA, identical EBITDA margins and identical revenues while having fundamentally different economics. The difference lies in how much of every pound of revenue remains after paying the direct costs of delivering the product or service.

The following example illustrates why buyers examine both metrics together.

Manufacturing Business

Engineering Consultancy

SaaS Software CompanyRevenue

£2,000,000

£2,000,000

£2,000,000

Gross Margin

40%

60%80%

Gross Profit£800,000£1,200,000£1,600,000Operating Expenses

£300,000£700,000£1,100,000EBITDA£500,000£500,000£500,000EBITDA Margin25%25%25%

Although all three businesses generate identical EBITDA, they tell very different stories.

The manufacturing business operates with relatively low gross margins because a large proportion of every sale is consumed by raw materials, production labour and logistics. Growth often requires additional inventory, labour and working capital, meaning each new pound of revenue produces comparatively little incremental profit.

The engineering consultancy generates a higher gross margin because its principal cost of sales is billable staff. Improvements in utilisation rates, pricing and project efficiency can materially increase profitability without significantly increasing fixed overheads.

The software business produces the highest gross margin because the cost of serving additional customers is relatively low once the platform has been developed. Although operating expenses such as product development, sales and marketing may currently suppress EBITDA, future revenue growth has the potential to generate disproportionately higher profits due to the scalability of the business model.

This distinction is one of the reasons technology businesses often command higher valuation multiples than labour-intensive businesses despite reporting similar EBITDA today. Buyers are purchasing future cash flows, not simply current earnings, and gross margin provides one of the clearest indicators of future operating leverage.

How Buyers Use Gross Margin During Due Diligence

Gross margin is one of the first metrics buyers benchmark against comparable businesses within the same sector.

Margins below the industry average may indicate excessive direct costs, weak pricing discipline, operational inefficiencies or an unfavourable customer mix. Conversely, margins significantly above the market average require explanation. 

Buyers will want to understand whether the premium results from genuine competitive advantage or temporary factors that may not be sustainable.

Gross margin also plays an important role in financial modelling. 

Acquirers use it to estimate the profitability of future growth initiatives. Businesses with high gross margins typically require less incremental expenditure to generate additional profit, allowing EBITDA to increase more rapidly as revenue grows. 

Businesses with low gross margins generally require proportionately more labour, materials or subcontractors to support growth, limiting operational leverage.

For this reason, two businesses with identical EBITDA today can have materially different valuations if one demonstrates a stronger capacity to convert future revenue into profit.

How Gross Margin Is Calculated

The calculation itself is straightforward.

Gross Margin (%) = (Revenue − Cost of Sales) ÷ Revenue × 100

The challenge lies in correctly identifying cost of sales.

Direct costs should include only those expenses directly attributable to producing or delivering the product or service. These commonly include raw materials, direct production labour, subcontractor costs, shipping, fulfilment costs and production overheads directly linked to output.

Operating expenses such as management salaries, office rent, marketing, finance costs, administration and professional fees should generally be reported below gross profit.

Although the principle appears simple, the distinction is frequently blurred within owner-managed businesses.

Common Classification Issues

One of the most common findings during financial due diligence is inconsistent cost classification.

Founders often perform operational roles while simultaneously managing the business. Their salaries may be partly attributable to service delivery and partly to management. Different accountants may classify these costs differently, affecting reported gross margins.

Similar issues arise with subcontractors, freelance specialists, warranty costs, implementation teams and customer support functions. Businesses with multiple revenue streams may also allocate shared costs inconsistently across different products or services.

Quality of Earnings advisers will normally restate historical financial information using consistent accounting policies across the review period. If costs are reclassified from operating expenses into cost of sales, reported gross margins decline. 

Even where EBITDA remains unchanged, buyers may conclude that the business possesses lower pricing power or weaker unit economics than originally presented.

For this reason, founders should ensure that cost classifications are consistent long before beginning a sale process.

Gross Margin Benchmarks by Business Model

Gross margin expectations vary significantly across sectors. Comparing margins across unrelated industries provides little insight; the appropriate comparison is always against direct competitors.

Software and SaaS (70–85%)

Software businesses typically generate the highest gross margins because serving additional customers involves relatively little incremental cost. Cost of sales usually consists of hosting infrastructure, third-party software licences, payment processing and customer support. Lower-than-expected margins often indicate excessive implementation work or a business that resembles a consultancy more than a software platform.

Professional Services (50–70%)

Consultancies, legal practices, engineering firms and accountancy businesses derive their gross margin primarily from the spread between employee costs and billable revenue. Improvements in utilisation, pricing and project management directly improve gross margins.

Managed Services and Outsourcing (30–50%)

Managed service providers, facilities management businesses and outsourced operations tend to have lower margins because delivery remains labour intensive. Buyers focus closely on contract profitability and whether newer contracts are being secured at lower margins than legacy agreements.

Manufacturing and Distribution (20–40%)

Manufacturing businesses typically generate the lowest gross margins because raw materials, production labour, energy and logistics consume a substantial proportion of revenue. Buyers examine whether margins have remained stable through changing commodity prices and supply chain disruptions.

Using Gross Margin to Strengthen the Investment Case

Gross margin should feature prominently within the Information Memorandum and the financial analysis supporting a sale process.

The strongest presentations typically include:

• A three-year gross margin trend demonstrating consistency or improvement.

• A year-on-year gross margin bridge explaining significant movements.

• Gross margin by business division, product line or customer segment.

• Analysis showing growth is concentrated in higher-margin activities.

• Comparison against relevant sector benchmarks.

• Commentary explaining why the business consistently achieves its margin profile.

Businesses that demonstrate stable or improving gross margins over several years reduce perceived risk for buyers. When those margins exceed sector averages for clearly identifiable structural reasons—such as proprietary technology, operational efficiency, premium positioning or superior pricing power—they provide compelling evidence in support of a premium valuation multiple.

Ultimately, EBITDA measures today's earnings. Gross margin explains the quality of those earnings and the business's capacity to generate even greater profits in the future. That is why sophisticated buyers evaluate the two metrics together rather than in isolation.

This entry is for general information only and does not constitute legal, financial or tax advice. Founders should obtain appropriate professional advice before acting on any of the matters discussed.