Margins: gross, operating, net
Margins turn absolute profit into a comparable percentage, exposing pricing power, cost discipline, and business model differences.
Three ratios, three questions
Gross margin is gross profit divided by revenue: how much of each sale survives the direct cost of delivering it. Operating margin adds the cost of running the company. Net margin includes financing and tax.
Software often shows 75%+ gross margins because copying code is nearly free. Grocers live near 25% because they physically buy and move goods. Neither is good or bad in isolation — compare a company to its own history and to direct peers.
Operating leverage
When costs are largely fixed, revenue growth lands disproportionately in profit, and margins expand. The same mechanism works brutally in reverse: a modest revenue decline can wipe out operating profit entirely.
Direction over level
A steadily rising gross margin suggests improving pricing power or mix. A falling one suggests discounting, input cost pressure, or a shift toward lower-quality revenue. Trend usually matters more than the absolute level.
Worked example
Operating leverage in both directions
- Revenue $100m, variable costs $40m, fixed costs $50m. Operating income = $10m, margin 10%.
- Revenue rises 20% to $120m; variable costs scale to $48m; fixed costs stay $50m.
- Operating income = $22m, margin 18.3% — profit more than doubled on 20% revenue growth.
- Now instead revenue falls 20% to $80m: variable $32m, fixed $50m, operating income = -$2m.
High fixed costs amplify both good and bad revenue years. Judge margin expansion in light of how much of it is simply leverage.
Common misconceptions
“Higher margin always means a better company.”
Margin levels are largely set by business model. A high-turnover low-margin retailer can out-earn a high-margin niche firm on capital.
“One quarter of margin decline signals decline.”
Seasonality, one-off costs, and investment phases move margins. Look across several years.
Checkpoint