Gross Margin Deep Dive: Practical COGS Fixes and Pricing Levers for Operators

What is Gross Margin and Why Does It Matter?

For an early-stage founder, every number on a spreadsheet tells a story about survival. While revenue gets the spotlight and cash in the bank dictates runway, gross margin is the quiet metric that predicts whether the business can ever be profitable. It is the core engine of your company. A low or miscalculated gross margin means that every new sale might actually be costing you money, pushing you closer to the edge instead of towards sustainable growth.

Understanding how to calculate and improve gross margin for startups is not just a financial exercise; it's a fundamental test of your business model's viability. This is about ensuring your operational costs vs revenue make sense before you scale.

A Foundational Understanding

Before diving into complex analysis, let's establish a simple, non-accountant definition. Gross margin is the portion of each dollar of revenue that you have left after paying for the direct costs of creating and delivering your product or service. The formula is: (Revenue - Cost of Goods Sold) / Revenue.

The Cost of Goods Sold, or COGS, represents these direct costs. It is crucial to distinguish COGS from Operating Expenses (OpEx). COGS are the variable costs tied directly to delivering your product; if you sell one more unit, these costs go up. OpEx are the fixed costs to run the business, like rent or marketing salaries, which do not change with each individual sale.

Why should this be a top focus over other startup financial metrics? Because gross margin reveals the health of your unit economics. If your margin is strong, it proves your core business is profitable and can support future growth and investment in sales, marketing, and R&D. If it is weak, scaling will only amplify your losses. It is the first and most important indicator of whether you have a scalable business or just a revenue-generating hobby.

How to Calculate Gross Margin Accurately: Avoiding the 3 Common COGS Traps

The biggest challenge in margin analysis for founders is getting the inputs right. An unreliable gross margin figure can lead to disastrous strategic decisions. The reality for most pre-seed to Series B startups is more pragmatic: you are likely using QuickBooks or Xero, not a complex ERP, and mistakes are common. Here are the three most frequent traps that lead to an inaccurate number.

Trap 1: The People Puzzle

Founders often struggle to classify salaries correctly. The key distinction is between costs to deliver a product versus costs to acquire a customer. Salaries for team members directly involved in delivering the service or supporting the product belong in COGS. The rule of thumb is simple: if the role exists to serve an existing, paying customer, it is likely COGS. If it exists to find a new customer, it is OpEx.

For example, consider a SaaS company. The salaries and loaded costs, including payroll taxes and benefits, for your customer support team, implementation specialists, and onboarding managers are part of COGS. Their job is essential to delivering the value the customer paid for. In contrast, the salaries and commissions for your sales team are OpEx because their work is focused on customer acquisition, not delivery. See headcount planning for guidance on budgeting salaries.

Trap 2: The Tech Stack Maze

For tech companies, allocating cloud hosting and software costs is a major source of error. You must separate costs for the production environment from costs for development and staging. Only the costs to run the live application that serves paying customers should be in COGS.

As an example, if your monthly AWS bill is $20,000, you need to analyze it. If $15,000 is for the production servers, databases, and services powering your live product, that is COGS. The remaining $5,000 spent on developer sandboxes, staging environments, and internal testing tools is an R&D expense, which falls under OpEx. This distinction is critical for accurate margin calculation and for correctly claiming innovation tax incentives, such as under US R&D tax credit regulations (e.g., Section 174) or the UK's HMRC R&D tax relief scheme.

Trap 3: The Physical World

For e-commerce businesses, COGS extends far beyond the cost of the product itself. Many founders using Shopify with QuickBooks or Xero initially forget to include all the ancillary costs of getting the product into a customer's hands. A scenario we repeatedly see is founders underestimating shipping and fulfillment costs, which crushes their margin.

A complete COGS list for a direct-to-consumer product should include:

• The unit manufacturing cost
• Inbound freight to your warehouse
• Import duties and tariffs
• Product packaging
• Fulfillment center pick-and-pack fees
• Payment processing fees from providers like Stripe
• Outbound shipping costs (if not billed separately to the customer)

Beyond a Single Number: Margin Analysis for Founders

Once you trust your gross margin number, the next step is to break it down. A single, company-wide margin hides critical information. To make better decisions and improve profitability for startups, you must perform segmented margin analysis. This means calculating margin not just for the whole company, but for each product line, customer segment, subscription tier, or even individual large client.

This process does not require complex software. You can build this in a spreadsheet. Using standard financial forecasting methods can help structure the rows and columns for Revenue, each major COGS component (like Hosting, Support Hours, or Materials), and a final calculated Gross Margin percentage. This structure immediately highlights which parts of your business are driving profit and which are a drain on resources.

The lesson that emerges across cases we see is that your highest-revenue customers are not always your most profitable. For instance, consider a professional services agency that analyzed its margin by client. They discovered their largest enterprise customer, who accounted for 30% of their revenue, was their least profitable. The client's constant demands for custom work and on-call support drove subcontractor and internal labor costs so high that their gross margin was near zero. This insight empowered them to renegotiate the contract from a position of data-driven strength, transforming a flagship account from a resource drain into a genuine profit driver.

Three Levers to Improve Profitability for Startups

After your analysis identifies a problem area, you have several levers you can pull to actively improve your unit economics and start reducing cost of goods sold. This is where you move from financial reporting to operational strategy.

Lever 1: Strategic Pricing

Often, the most direct way to fix a margin problem is to adjust pricing. If a specific customer segment or product tier is unprofitable, it may be fundamentally underpriced for the value and support it requires. Your segmented analysis provides the exact data needed to justify these changes.

For example, a B2B SaaS company used margin analysis to find that its lowest-priced subscription tier was consuming a disproportionate amount of customer support resources, resulting in a negative gross margin for that segment. Armed with this data, they confidently eliminated the free support for that tier and introduced a paid support add-on. This not only fixed the margin issue but also encouraged many users to upgrade to a higher tier with support included, boosting both gross margin and overall revenue.

Lever 2: Direct Cost Negotiation

Don't assume your current COGS are fixed. Systematically review your largest variable costs and look for opportunities to negotiate. For tech companies, cloud infrastructure is a prime target. Cloud cost savings from negotiating for reserved instances or savings plans can be 20-40%. For e-commerce businesses, payment processing is another key area. The threshold for negotiating lower payment processing fees is often greater than $1M per year in volume. Once you cross that line, you have leverage to lower your rates.

The same principle applies to raw materials, shipping carriers, and key software licenses. Systematically review contracts, then negotiate. Use the data from your segmented analysis to ask for meaningful concessions. A practical framework for structuring those conversations can be found in this guide to vendor negotiation: financial framework.

Lever 3: Product and Process Efficiency

Sometimes, the problem is not price or supplier cost, but an inefficiency in your product or delivery process. High support costs for a specific feature can indicate a design flaw or a confusing user experience. Improving the product itself can be a powerful way of reducing the cost of goods sold.

Consider a company that found one product feature was responsible for 50% of its support tickets. This drove up the allocated support salary cost in COGS, making that feature a drag on profitability. Instead of raising prices, they invested in fixing the feature's user interface. The fix led to a dramatic drop in support tickets, which directly increased the gross margin without any change in price or supplier cost.

Practical Steps for Improving Gross Margin

For an operator at a Pre-Seed to Series B startup, mastering gross margin is not an abstract accounting goal; it is a tool for survival and growth. The path forward is clear and can be managed within your existing tools like QuickBooks and Xero.

1. Focus on accuracy. Go through your COGS line by line, applying the correct classifications for people, technology, and physical goods. An incorrect number is worse than no number at all. In the US, this should align with US Generally Accepted Accounting Principles (US GAAP), while UK companies will typically follow Financial Reporting Standard 102 (FRS 102). It is also important for UK operators to track revenue against the VAT registration thresholds, which changed in 2024.
2. Move beyond a single metric. Segment your margin analysis by product, customer, or service line to find your true profit drivers. This granular view is where actionable insights live.
3. Act on what you find. Use your insights to guide pricing strategies, negotiate with vendors, and drive product improvements. While the benchmark for a "good" SaaS gross margin is over 75-80%, according to sources like Bessemer's State of the Cloud reports, the goal for any business is constant, informed improvement. You can find more SaaS spending benchmarks for context.

Your gross margin is the most direct reflection of your business's fundamental health. Treat it that way. For broader context on this topic, see Finance for Generalist Operators.

Frequently Asked Questions

Q: What is a good gross margin for an e-commerce business?
A: Gross margin benchmarks for e-commerce vary widely by niche but typically range from 40% to 60%. Businesses with unique or proprietary products often achieve higher margins, while those selling competitive goods face more pressure. Key factors influencing this are manufacturing costs, shipping fees, and payment processing rates.

Q: Are marketing and advertising costs part of COGS?
A: No, marketing and advertising expenses are not included in COGS. They are considered an Operating Expense (OpEx) because they are costs to acquire new customers, not to produce or deliver the product itself. COGS only includes the direct costs tied to creating and delivering your goods or services.

Q: How often should an early-stage startup review its gross margin?
A: An early-stage startup should review its gross margin monthly. This frequency allows you to quickly spot negative trends in pricing, supplier costs, or operational efficiency. As the business matures and costs stabilize, a quarterly in-depth review may be sufficient, but monthly monitoring remains a healthy practice.