Gross Margin and Differences by Industry
SaaS at 80%, Retail at 20% — This article explains why gross margin varies significantly across industries and how to interpret these figures.
What is Gross Margin?
Gross Margin is the ratio of gross profit to revenue, where gross profit is revenue minus cost of goods sold (COGS). COGS refers to the direct costs incurred in producing and selling products or services, such as raw materials, production labor costs, and merchandise purchase costs. Selling, general, and administrative (SG&A) expenses like advertising costs, headquarters administrative expenses, and research and development costs are not included here.
For example, if annual revenue is $100 billion and COGS is $60 billion, then gross profit is $40 billion, and the gross margin is 40%. This figure is the primary profitability indicator, showing 'how much is left after deducting costs when selling one unit of a product'. This article is for educational purposes and does not recommend buying or selling any specific stock.
Why Does It Vary So Much Across Industries?
The key lies in the magnitude of 'additional direct costs incurred to sell one more unit'. For SaaS (cloud software) companies, once the code is developed, even if one more customer is added, the additional costs are typically limited to server and payment processing fees, often resulting in gross margins of 70-80%. In contrast, for retail businesses, most of the revenue goes towards the cost of purchasing goods, so gross margins tend to hover around 20%.
Manufacturing industries fall in between. Raw materials and factory labor costs account for a significant portion of COGS, typically placing gross margins in the 20-40% range. Even within manufacturing, industries with strong brand premiums like cosmetics and luxury goods can exceed 50%, while those with intense price competition, such as home appliances and components, tend to have lower margins. In essence, gross margin is a condensed figure representing a business's cost structure and pricing power.
How to Interpret the Figures
Directly comparing absolute figures across different industries is not very meaningful. A supermarket's 22% gross margin does not imply 'worse management' than a software company's 75%. Comparisons should be made among competitors within the same industry and by observing a company's own trends over time. If the retail industry average is 20% and a particular company achieves 28%, one can infer that it has an advantage in purchasing negotiation power or a higher proportion of private label (PB) products.
Trends are also important. If gross margin consistently rises over several quarters, it signals that price increases are effective or cost control is well-managed. Conversely, if it falls, one should examine the business report to determine whether it's due to rising raw material prices, increased discount competition, or a deteriorating product mix.
Why It Should Be Viewed Alongside Operating Margin
A high gross margin does not necessarily mean a company is highly profitable. Even if a SaaS company has an 80% gross margin, it often incurs substantial marketing and development expenses to acquire new customers, leading to an operating loss. Operating profit is calculated by subtracting SG&A expenses from gross profit, and the ratio is the operating margin.
For instance, if a company with an 80% gross margin spends 70% of its revenue on marketing and R&D, its operating margin shrinks to 10%. Conversely, a retail business with a lower gross margin of 20% can still achieve a 15% operating margin if it keeps SG&A expenses to 5%. Therefore, gross margin, which indicates 'cost efficiency,' and operating margin, which reflects 'overall operational efficiency,' should be read together as complementary indicators.
Common Pitfalls and Limitations
First, accounting standards for COGS can vary between companies and countries, potentially distorting simple comparisons. Some companies include logistics costs in COGS, while others classify them as SG&A expenses, meaning a superficial difference in gross margin might not reflect an actual difference in competitiveness. Second, for companies with multiple business segments, the overall average gross margin can obscure the true performance of individual divisions.
Third, temporary factors should not be mistaken for trends. If gross margin fluctuates in a single quarter due to sharp currency movements or a one-time inventory loss, one should not make judgments based solely on that single data point. Before concluding that a single figure is good or bad, one should be able to explain its level based on the cost structure and industry characteristics.
Key Takeaways
Gross margin, calculated as (Revenue - COGS) / Revenue, is the primary profitability indicator that condenses a business's cost structure and pricing power. The higher gross margin for SaaS and lower for retail is not a matter of superiority or inferiority, but rather a difference in the direct costs incurred to sell one additional unit. Therefore, it should be interpreted by comparing it with competitors within the same industry and by observing a company's own trends, rather than directly comparing absolute figures across different industries.
Finally, gross margin becomes more meaningful when viewed in conjunction with operating margin and net profit margin. This is because even with good cost efficiency, SG&A expenses can consume all the profit. It is only when one can filter out accounting classification differences and one-time factors, and explain 'why this number is what it is,' that gross margin is truly utilized effectively.
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