Gross Margin

What is gross margin?

Gross margin (German Bruttomarge) refers to the share of revenue that a company retains after deducting the costs incurred directly by the products or services sold. Gross profit margin (Bruttogewinnmarge) means the same thing. An ice cream parlour that sells a scoop for EUR 2.00 and spends EUR 0.60 on ice cream, cup and spoon keeps EUR 1.40 per scoop, or 70% of the price. Rent, staff and everything else must still be paid from that amount. In the same way, a company pays all its other costs, such as sales, administration and product development, from this remainder before any profit arises.

The directly attributable costs are called cost of revenue (in retail also cost of goods sold). The amount in euros that remains after deducting them is called gross profit (Bruttoergebnis); gross margin expresses it as a proportion of revenue. This differs from the gross trading profit (Rohertrag), in which only the cost of materials or goods is deducted from revenue. Gross margin appears in the financial model, in the presentation for investors (pitch deck), in monthly reports and in every financial due diligence, the review of the financial figures by investors or buyers. The company itself decides which costs belong in it, and this is its most important weakness.

Calculating gross margin: formula and cost of revenue

Formula: Gross profit = revenue minus cost of revenue; gross margin = gross profit / revenue × 100%

Revenue means net revenue excluding value added tax and after discounts, credit notes and returns. This corresponds to revenue (Umsatzerlöse) under Section 277(1) of the German Commercial Code (Handelsgesetzbuch, HGB), from which revenue reductions such as discounts and cash discounts as well as value added tax are to be deducted.

Subscription software

For software provided as a subscription over the internet (software as a service, SaaS), four items typically belong in cost of revenue. Two of them are non-personnel costs: operation on servers and in the cloud (hosting) and licences for third-party software in the product. The other two are personnel costs for customer support and technical operations and for setting up the customer (onboarding), including data migration and training. Product development, sales and marketing are not included. This delineation is the most important lever of the metric: anyone who allocates support costs to development reports a higher gross margin without anything changing economically.

Retail and e-commerce

In retail, most of the cost of revenue consists of the cost of goods sold, that is, the purchase price of the goods sold including freight and customs duty. Whether shipping to the customer, packaging, payment fees and returns handling are also deducted is inconsistent. Some online retailers show these costs in gross margin, others only in the contribution margin, the amount left from revenue after deducting all variable costs. Comparisons are therefore only meaningful if the definition is known.

Gross margin in annual financial statements under the HGB

The annual financial statements under the German Commercial Code (HGB) do not recognise the term gross margin. Which figure comes closest depends on how the income statement (profit and loss account, GuV) is structured. The HGB permits two methods.

Total cost method: Rohertrag and Rohergebnis

Under the total cost method (Gesamtkostenverfahren) in Section 275(2) HGB, which is common in Germany, expenses are classified by type, such as cost of materials and personnel expenses. In practice, the Rohertrag results from revenue, plus or minus changes in inventories of self-produced finished goods not yet sold, minus cost of materials. Under Section 276 HGB, small and medium-sized corporations (Kapitalgesellschaften) may combine several items into the Rohergebnis (combined gross result). It additionally includes, among other things, other operating income, and revenue is then not shown separately.

For software and service companies, this means: personnel costs for support or set-up are in personnel expenses, not in cost of materials. The Rohertrag is therefore regularly higher than the gross margin the company uses for internal management.

Cost of sales method: gross profit from revenue

Under the cost of sales method (Umsatzkostenverfahren) in Section 275(3) HGB, expenses are classified by function. The cost of production of the services rendered to generate the revenue is deducted from revenue, and the balance is called gross profit from revenue (Bruttoergebnis vom Umsatz). It comes closer to gross margin because personnel costs of service delivery are also deducted, but it depends on how the company allocates costs to production, sales and administration.

Gross margin in valuation and due diligence

Gross margin and revenue multiple

Growth companies are often valued at a multiple of their revenue (revenue multiple). This assumes that the revenue will later turn into high profits, and that only works if a lot is left after the cost of revenue. Two companies with the same revenue and growth therefore receive different valuations if one achieves a gross margin of 80% and the other 40%. In the second case, investors apply lower multiples or calculate with gross profit instead of revenue.

For subscription software, investors in practice often expect gross margins of 70% and more. High shares of hardware, services or third-party licences lower the margin. The question then arises in the business valuation whether the business should be valued more like software or like a service business.

Review in due diligence

In due diligence, gross margin is derived afresh from the accounting data. The review looks at which accounts are allocated to cost of revenue and whether this allocation remained the same across all periods. The reviewers also ask whether personnel costs for support and set-up were shifted into development or sales. For platforms that broker third-party services, there is the further question of whether they show the entire brokered volume or only their commission as revenue. If the result deviates from the figure in the pitch deck, the valuation rests on the verified figure.

Worked example: calculating gross margin for software and retail

A software company generates EUR 4,000,000 in net revenue. It books hosting and third-party licences as purchased services in cost of materials, and support and set-up in personnel expenses.

• Hosting and cloud infrastructure: EUR 360,000
• Third-party licences in the product: EUR 120,000
• Personnel for customer support: EUR 280,000
• Personnel for set-up at the customer: EUR 240,000
• Total cost of revenue: 360,000 + 120,000 + 280,000 + 240,000 = EUR 1,000,000
• Gross profit: 4,000,000 minus 1,000,000 = EUR 3,000,000
• Gross margin: 3,000,000 divided by 4,000,000 = 75%
• Rohertrag under the total cost method: 4,000,000 minus 480,000 cost of materials = EUR 3,520,000, which is 88% of revenue

An online retailer generates EUR 2,500,000 in net revenue after returns. The cost of goods is EUR 1,375,000, shipping to the customer EUR 200,000 and payment fees EUR 50,000.

• Rohertrag: 2,500,000 minus 1,375,000 = EUR 1,125,000, gross margin under the narrow definition 1,125,000 divided by 2,500,000 = 45%
• Gross margin under the broader definition: 1,125,000 minus 200,000 minus 50,000 = EUR 875,000, divided by 2,500,000 = 35%
• For comparison, the markup on the cost price, that is, the purchase price including incidental acquisition costs: 1,125,000 divided by 1,375,000 = 81.8%

The result means: if the revenue of both companies grows by EUR 1 million at the same margin, an additional EUR 750,000 is available to the software company for development, sales and administration. For the retailer, depending on the definition, it is EUR 350,000 to EUR 450,000. At the same time, the example shows why the definition must be disclosed: between the Rohertrag and the gross margin relevant for management, there are 13 percentage points for the software company and 10 for the retailer.

Distinction: gross margin, contribution margin, EBITDA margin and markup

• Contribution margin: deducts all variable costs from revenue, including revenue-dependent sales costs such as commissions, but no fixed costs. Because cost of revenue often contains fixed components, such as a permanently employed support team, it is higher or lower than gross profit depending on the cost structure.
• EBITDA margin and operating margin: The EBITDA margin relates earnings before interest, taxes, depreciation and amortisation to revenue and therefore also takes account of sales, administration and development. The operating margin (EBIT margin) additionally deducts depreciation and amortisation.
• Markup (Kalkulationsaufschlag): relates the Rohertrag to the cost price instead of the selling price.
• Fixed and variable costs: Cost of revenue is predominantly, but not entirely, variable. A permanently employed support team causes costs of the same size at first even if revenue falls.

Common mistakes

• Cost of revenue shifted. Support, set-up or hosting are allocated to development or administration. The margin rises on paper and falls back to its actual level in due diligence.
• Rohertrag presented as gross margin. The Rohertrag under the total cost method overstates the margin for software and services because personnel costs are missing.
• Gross and net revenue mixed up. Revenue including value added tax, or before returns and discounts, distorts the metric.
• Margin and markup confused. Anyone who calculates with a markup of 50% achieves a margin of only 33.3%. Pricing decisions made on the wrong basis lead to under-recovery.
• Average conceals differences. An overall margin can consist of a software business with a high margin and a growing services business with a low margin. Only the breakdown by revenue type shows where it is heading.

Frequently asked questions

Is gross margin the same as the Rohertrag?

Not necessarily. The Rohertrag under the total cost method deducts only the cost of materials, whereas gross margin in the sense of company management also deducts personnel costs and other costs of service delivery. In retail, the two figures are often close together; for software and services, they can be far apart.

What is the difference between gross margin and net margin?

Gross margin deducts only the cost of revenue from revenue, whereas net margin deducts all expenses down to net income for the year, that is, also sales, administration, development, depreciation and amortisation, interest and taxes. Net margin corresponds to return on sales based on net income for the year (net profit margin). EBITDA margin and operating margin lie between the two.

Is a company with a high gross margin profitable?

Not necessarily. Gross margin shows only what is left after the direct costs. A software company with an 80% gross margin still makes losses if sales, development and administration cost more than gross profit. Only the operating margin and the net margin show whether a profit arises.

Do personnel costs belong in cost of revenue?

Yes, to the extent that they directly serve service delivery. This concerns, for example, support, technical operations and set-up at the customer. Personnel for developing new features, for sales and for administration are not included.

What is a good gross margin?

That depends on the business model. As a rule of thumb, 70% and more is considered good for subscription software; retail, hardware and services are usually lower. For lower values, investors mainly ask whether the share of low-margin revenue falls as the company grows. Values can only be compared if the cost of revenue is delineated in the same way.

How does growth change gross margin?

For software, it often rises with size, because infrastructure and support are spread across more customers; this is a core part of scalability. If the margin falls despite growth, this points to price pressure or rising costs per customer.

The Roemer Capital view

Before we prepare a funding round or a sale, we derive gross margin afresh from the client's accounting. We fix its definition in writing: which accounts belong to cost of revenue and how the metric can be reconciled to the Rohertrag in the annual financial statements. This definition then applies equally in the financial model, in the pitch deck and in the data room, so that investors and buyers find the same figure in their review.

If the margin is below what is expected for the business model, we show openly which costs make up the gap and how it can be closed. Where we take over the finance function for a period as fractional CFO, we report the metric monthly according to exactly this definition.