We look closely at gross margins (GM) at Shearwater. Think of GM as what’s left of your revenue after you take out direct costs. If you’re a milk producer, then your GM is likely to be quite low once you remove the cost of the milk, bottles and so on. Tech companies often have high GMs as the cost to serve an additional ‘widget’ is near-zero. This can mean super-profits as revenues grow. Facebook has a GM% in the 80s, whereas Volkswagen Group is closer to 20%.
But here’s the interesting thing: Not all gross margin is the same. Fred Wilson explains that if your direct costs are effectively pass-through, then this is superior to active direct costs. “If [the costs of goods] is very little to no effort, and largely just an accounting entry, then you may have a “low margin business” that is actually a high margin business.” The trick is to understand when GM is active or passive.
We can extend this idea further, and look at the timing of the direct costs. If they occur after the revenue has been achieved, they may present a more attractive model than those that are a precursor to revenue. A shop that needs to buy clothes before it can sell them incurs that direct cost upfront, before any sales are actually made.