Gross Margin In A Nutshell: Gross Margins vs. Moats

The gross margin is a financial ratio metric, which helps assess the profitability of a business and also its operational efficiency. Indeed, as gross margins take into account the cost of goods sold (the cost incurred to deliver the software to the customer) it’s a measure to assess the value of a business.

Gross margin in a nutshell

This is the relationship between Gross Profit and sales, and it is expressed in percentage:

(Gross Profit (Revenue – CoGS) / Sales) x 100%

Imagine, company XYZ had $100K in Gross profit and $250K in Sales, for Year Two, therefore:

(100/250) * 100% = 40%

It means that 60% of your income is used to cover the cost of goods sold.  This ratio is critical, since for many organizations, in particular, manufacturing, most of the costs are associated with CoGS (Cost of Goods Sold). 

For example, if you have to produce an Ice cream, you have to buy raw materials to make it. Also, someone has to “assemble” the Ice cream before it can be sold. 

Well, the raw materials and the work needed to produce the final product are considered CoGS. In other words, those are the costs required before the Ice cream can be sold.  

Therefore, this measure can be beneficial to assess the operational profitability of the business.

Why gross margins matter

David George and Alex Immerman, partners at the venture capital firm a16z highlighted, “A high gross margin is a preferred business feature. Higher gross margins allow for more percentage points of revenue to be spent on growth and product development.”

This is a critical element to understand, as software companies, while usually carrying higher gross margins than traditional organizations are more focused on physical infrastructure.

Those same software companies’ products also might become outdated quickly, as technology evolves.

In addition, in order to distribute software and enable its continuous growth, it requires massive investments in marketing and sales.

For instance, Salesforce, among the most valuable software companies, in terms of market cap, in 2020 spent more than 46% of its revenues on sales and marketing.

Compared to 25% in total for the cost of goods sold, and 16% for product research and development (FourWeekMBA Analysis).

As David George and Alex Immerman, further pointed out “higher gross margins also tend to translate to higher cash flow margin, and in a world where ‘how much runway do you have’ has become an (if not, the) preeminent question, cash is paramount. For these reasons, high gross margin companies typically have higher revenue multiples than their low gross margin counterparts.

Less risk aversion more gross margins

As Fred Wilson, from AVC, pointed out in “The Great Public Market Reckoning,”

If you look at the class of companies that have come public in the last twelve months, many of the stocks that have performed the best are software companies with software margins. One notable exception to that is Beyond Meat.

He mentioned examples like Zoom, Cloudfare, and Datadog. Where other companies, like Uber, Lyft and Peloton were losing value.

In short, he pointed out how in times when investors are more risk averse gross margins become secondary.

However, where there is more market risk aversion, gross margins become extremely important.

Gross margins vs. moats

David George and Alex Immerman also point out how looking at gross margins alone are misleading, as it makes you forget what really drives business value.

As they further point out “business quality is about defensibility. Defensibility comes from moats.”

In short, if a company is focusing on higher gross margins at the expense of business defensibility that might over time translate into a

loss of competitiveness of the business.

As they point out, companies like Apple, Walmart, Netflix, and others, have much lower margins compared to software companies, and yet, those are among the most valuable brands in the world.

But what makes up a moat? There are several ways to build moats and some of them are:

Economies of scale

External economies of scale describe factors beyond the control of a company that is present in the same industry and that lead to cost benefits. These factors may be positive or negative industry or economic trends. External economies of scale, therefore, are business-enhancing factors occurring outside a company but within the same industry.

Which enables companies to improve efficiency and profitability as the company scales (beware though of diseconomies of scale).

Differentiated technology

In a software world where hundreds of new products are launched to the market every day, building up differentiation (in terms of features, technology, and value proposition) is a key element.

Network effects

A platform business model generates value by enabling interactions between people, groups, and users by leveraging network effects. Platform business models usually comprise two sides: supply and demand. Kicking off the interactions between those two sides is one of the crucial elements for a platform business model’s success.

This is true for platform business models.

Where in economies of scale the company gains in efficiency and profitability as it grows (it lowers its per cost unit).

In network effects, the platform becomes more valuable as its per-user value grows as more users join (beware of negative or reverse network effects).

Direct brand

One of the most powerful business defenses is the brand or the direct access to your customer base.

For instance, if you take Facebook, it’s still among the most valuable websites on earth, because people recognize its brand.

There is no intermediary, people access their Facebook app, or go directly to the Facebook login page.

This is critical, as over time it defends against disintermediation.

If let’s say, Facebook depended solely on traffic coming from Google, the day Google had launched its social network, it would have killed Facebook.

Yet, as the product and brand were recognized and people got straight to the source, it didn’t need any intermediary.


A distribution channel is the set of steps it takes for a product to get in the hands of the key customer or consumer. Distribution channels can be direct or indirect. Distribution can also be physical or digital, depending on the kind of business and industry.

Strong products and brands can draw directly from their user or customer base.

Having a strong distribution network is also a key element. As highlighted in the Google TAC and if we look at the costs associated with the money invested into the distribution of some of the most valuable brands, this goes in the multi-billion dollar mark.

The traffic acquisition cost represents the expenses incurred by an internet company, like Google, to gain qualified traffic – on its pages – for monetization. Over the years Google has been able to reduce its traffic acquisition costs and in any case, keep it stable. In 2021 Google spent 21.75% of its total advertising revenues (over $45.56 billion) to guarantee its traffic on several desktop and mobile devices across the web.

Value proposition and perception

A value proposition is about how you create value for customers. While many entrepreneurial theories draw from customers’ problems and pain points, value can also be created via demand generation, which is about enabling people to identify with your brand, thus generating demand for your products and services.

Understand what’s the killer use case that makes your product value in the hands of several types of customers is another key ingredient.

While this might go beyond the engineering world, and as such it might seem foggier, it is though one of those elements that make a long-term difference.

In short, are you willing to test, and experiment with your product to find value propositions that fit the market?

If so, your product will evolve contextually, to create moats.

Those factors combined are all part of your business model recipe, and it often becomes evident only in hindsight.

And it takes years to build. What’s left is a lot of business experimentation, and a strong long-term vision.

Connected metrics

Profit Margin

The profit margin is a profitability financial ratio, given by the net income divided by the net sales, and multiplied by a hundred. That is expressed as a percentage. That is a key profitability measure as combined with other financial metrics, it helps assess the overall viability of a business model.

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Business Analysis

Business analysis is a research discipline that helps drive change within an organization by identifying the key elements and processes that drive value. Business analysis can also be used in Identifying new business opportunities or how to take advantage of existing business opportunities to grow your business in the marketplace.

Cash Flows

The cash flow statement is the third main financial statement, together with the income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing, and financing. The cash flow statement can be prepared with two separate methods: direct and indirect.

Comparable Analysis

A comparable company analysis is a process that enables the identification of similar organizations to be used as a comparison to understand the business and financial performance of the target company. To find comparables you can look at two key profiles: the business and financial profile. From the comparable company analysis, it is possible to understand the competitive landscape of the target organization.

Cost Structure

The cost structure is one of the building blocks of a business model. It represents how companies spend most of their resources to keep generating demand for their products and services. The cost structure together with revenue streams, help assess the operational scalability of an organization.

Financial Moat

Economic or market moats represent long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Financial Statements

Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory for companies for tax purposes. They are also used by managers to assess the performance of the business.

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