Key Insight
Gross margin tells you how much the product or service actually earns before corporate overhead absorbs it. Low gross margin businesses have less room for error — every overhead increase comes directly out of the owner's pocket.
The Formula
Gross Margin % = (Revenue − COGS) ÷ Revenue × 100
COGS includes direct costs to deliver the product or service: materials, direct labor, subcontractors, shipping, and production-related overhead. It excludes G&A expenses like rent, management salaries, marketing, and utilities.
Why Gross Margin Matters for Acquisitions
SDE sensitivity: A business with 30% gross margin has $30 of gross profit for every $100 of revenue. Each additional dollar of overhead (or manager replacement cost) directly reduces SDE. A business with 70% gross margin has more buffer.
Multiple justification: High-gross-margin businesses (SaaS, consulting, certain services) command higher multiples because each incremental revenue dollar is more profitable. Low-gross-margin businesses (distribution, certain manufacturing) trade at lower multiples for the same reason.
Benchmarking: Industry-specific gross margin benchmarks exist. A business significantly below industry average is either buying growth through unprofitable pricing, has cost inefficiencies, or is misclassifying expenses. All three warrant investigation.
Common Misclassifications
Owners sometimes misclassify operating expenses as COGS (to lower reported net income for tax purposes) or understate COGS (to make gross margins look higher than they are). A normalization step in due diligence should reclassify expense lines consistently with industry standards.
Software business: 75-85% gross margins typical. HVAC contractor: 35-50%. Food distributor: 12-20%. Restaurant: 55-65% food cost (inverted — COGS is 35-45%). Comparing SDE multiples across industries without understanding gross margin differences is a category error.
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