Gross Margin

What gross margin actually measures

Gross margin is the first profitability indicator in the income statement — it shows how much remains of every krona of revenue after the company has paid for the goods it sold. The formula is elegant in its simplicity: (Net revenue − Cost of goods sold) / Net revenue. But behind this line hides the company's business model in pure form. A company with 80% gross margin sells something that costs almost nothing to produce — software, licences, digital services. A company with 15% gross margin sells something where the cost of goods eats almost everything — raw materials, distributed goods, commodity manufacturing. Gross margin is thus not just a number — it is a diagnosis of what the company does. Atlas Copco has gross margin ~38% (compressors with a high technical moat + service), H&M ~52% (clothes with a brand premium), AstraZeneca ~80% (pharmaceuticals with patents). The same variable, three completely different business models — all mutually incomparable in absolute terms.

💡 INSIGHT

Gross margin tells you WHAT the company sells — not HOW IT is run. A company with 80% gross margin can still make a loss if sales and admin costs eat up the rest. A company with 20% gross margin can be very profitable if operating costs are extremely low (the Walmart model).

Why gross margin is the first profitability indicator

In the income statement, revenue flows downwards through a series of deductions: first COGS (cost of goods sold), then sales costs, then admin, then R&D, then depreciation, then interest, then tax. Each line is a margin. Gross margin is the FIRST — it shows whether the basic conditions exist. If gross margin is negative (a company sells below the cost of goods) there is nothing to save — no efficiency gains in sales or admin can compensate for selling the goods at a loss. This was the case for many food delivery companies in 2020-2022: gross margin was often -10% to +5% after discounts and cash compensation to the restaurants, meaning every order destroyed value regardless of volume. AKM1 has gross margin as its first profitability variable precisely because it sets the foundation: is there a business here, or is there not?

📖 DEFINITION

Gross margin = (Net revenue − Cost of goods sold) / Net revenue × 100. Also called 'gross margin' or 'gross profit margin'. COGS includes raw materials, components, direct production labour, and production-related overheads.

The three dimensions of gross margin

An analyst decomposes gross margin into three dimensions. First: pricing power — can the company charge a premium price? A company that raises prices 5% without losing customers has pricing power, which shows up as rising gross margin. Second: cost efficiency — can the company lower the cost of goods? A company that negotiates better supplier agreements, automates production, or moves to low-cost countries lowers COGS and raises gross margin. Third: product mix — does the company sell a larger share of high-margin products? A company that goes from selling 50% low-margin products to 30% has improved its mix and raised gross margin. These three dimensions are decisive: gross margin can rise for the right reason (price power, efficiency, mix) or the wrong reason (one-off inventory gains, accounting changes, underinvestment in quality). An analyst always asks: WHY did gross margin change?

⚡ KEY INSIGHTS Gross margin shows how much of every krona of revenue remains after the cost of goods — the first profitability indicator The level of the gross margin reveals the business model: SaaS 80%, pharmaceuticals 75%, industry 30-40%, retail 50%, commodity 10-20% Decompose into price power, cost efficiency, and product mix to understand WHY the margin changes Negative gross margin = the company sells below the cost of goods = nothing to save 2

Pricing power — moat in practice

Pricing power is the most valuable property a company can have. It means the company can raise prices without customers fleeing. This is Warren Buffett's definition of a moat: 'The most important thing is to figure out whether a company has pricing power.' A company with pricing power has gross margin that rises over time — not necessarily dramatically, but persistently. Atlas Copco has raised gross margin from ~32% (2014) to ~38% (2023) through a combination of premium pricing on technology, a service-and-consumables model (where spare parts have 60%+ gross margin), and mix skew towards more expensive compressor solutions. This is moat in practice. A company WITHOUT pricing power — typically commodity manufacturers or distributors in competitive markets — has gross margin that is unchanged or falling. They must accept the market price. The difference between these two companies in stock returns over 10 years is massive.

✓ TIP

Look for companies that report 'price growth' separately from 'volume growth'. Price growth > inflation = pricing power. Price growth < inflation = the company is losing power. Atlas Copco often reports +3-5% annual price growth — that is a moat indicator.

Cost control — operational excellence

The second driver is cost control — the company's ability to lower the cost of goods per unit. This can happen through: 1) economies of scale (larger production volumes lower the unit cost), 2) vertical integration (the company produces its own components instead of buying them), 3) automation (machines instead of people), 4) supplier negotiations (large volumes = better prices), 5) offshoring (production in low-cost countries). H&M is an example of cost-control-driven gross margin — they have kept gross margin around 50-55% for 20 years by combining large purchasing volumes, production efficiency in Asia, and design optimized for material consumption. But H&M has no pricing power — they cannot raise prices without losing customers to Zara, Uniqlo, etc. Their gross margin is stable but not rising. The contrast with Atlas Copco (rising) illustrates the difference between moat companies and efficiency companies.

⚠️ WARNING

Cost control has a lower bound — you cannot lower the cost of goods indefinitely. Too low costs can harm quality, brand, and customer experience. Sears, Kmart, and Toys R Us tried to squeeze costs for decades and died. Pricing power has no such bound — it can grow for decades.

How to distinguish pricing power from cost control

When gross margin rises, ask: is it price or cost? This is best seen in three steps. First: compare gross margin with inflation. If inflation is 3% and gross margin rises 2pp, it is probably cost efficiency (prices held, costs falling relatively). If gross margin rises 5pp when inflation is 3%, it is probably pricing power (prices raised faster than costs). Second: look at competitors' gross margin. If the company rises and competitors are unchanged, it is a company-specific moat. If everyone rises, it is industry-wide cost efficiency (perhaps an automation wave). Third: read the CEO letter for 'price' or 'pricing'. Companies with pricing power usually mention it explicitly: 'we carried out price increases of 4% in Q2 without impact on volume'. Silence about price = probably no pricing power. Erik Penser Bank has written excellent analyses of Swedish industry where pricing power is an explicit criterion.