Gross margin is the percentage of your revenue left after paying the direct cost of the goods or services you sold. It is calculated as revenue minus cost of sales, divided by revenue, and it tells you how much of each pound of sales is available to pay for marketing, overheads and profit.
How gross margin works
The formula is simple: (revenue − cost of goods sold) ÷ revenue × 100. Cost of goods sold, often shortened to COGS, means the costs that rise directly with each sale. For an online shop that is the product cost, inbound shipping and packaging. For a service business it is the time of the people delivering the work and any subcontractors. Rent, software subscriptions and marketing are not part of it; they are operating costs that come out of the gross profit.
If you are VAT-registered, calculate gross margin on revenue excluding VAT. The VAT you charge customers is not your money; it goes to HMRC. Here is an example from a candle maker in Brighton:
| Item | Amount |
|---|---|
| Price paid by the customer (including 20% VAT) | £30.00 |
| Revenue excluding VAT | £25.00 |
| Wax, wick, jar, label and box | £8.00 |
| Gross profit | £17.00 |
| Gross margin (£17 ÷ £25) | 68% |
Using the £30 VAT-inclusive price instead would give 73%, an overstatement that flows straight into every decision built on it.
Gross margin is not the same as markup. Markup compares the profit with the cost (£17 ÷ £8, about 213%), while margin compares it with the selling price. Mixing the two up is one of the most common pricing errors.
Why it matters for marketing
Gross margin sets the limit on what you can afford to pay for a sale. Your break-even return on ad spend is 1 ÷ gross margin. At a 68% margin, you break even at a ROAS of about 1.47, measured on ex-VAT revenue. A retailer working on a 25% margin needs a ROAS of 4 just to cover the product cost, before any other expense.
This is why two businesses with the same ROAS can be in very different positions. It also explains why many advertisers move from ROAS to profit on ad spend, which measures returns in gross profit rather than revenue.
Service businesses can apply the same logic to leads. If a typical job brings in £2,000 excluding VAT at a 40% gross margin, there is £800 of gross profit to cover the cost of winning it, including the cost of all the enquiries that never become work.
Common mistakes
- Calculating on VAT-inclusive revenue. Many ad platforms and shop dashboards report revenue including VAT and delivery charges, which flatters ROAS.
- Using one blended margin. A shop selling both high-margin accessories and low-margin electronics needs different targets for each.
- Ignoring discounts and returns. On a 40% margin, a 20% discount code halves the gross profit on each sale, and a high return rate erodes it further.
- Confusing margin with markup. Pricing at “50% markup” gives a 33% margin, not 50%.
How to act on it
Work out gross margin by product category, on ex-VAT revenue, after typical discounts. Then check what revenue figure your ad platforms receive: in GA4 and Google Ads, conversion value may include VAT and shipping, depending on how your tracking was set up. Set ROAS targets for each margin band, and go one step further with contribution margin, which also subtracts payment fees, delivery and returns.
My free ROAS and break-even calculator does the arithmetic for you. If you want ad accounts built around margin rather than revenue, that is how I run performance marketing.