Introduction
In retail, margins move in basis points, and they usually move in the direction sales take them. A retailer with rising comparable sales spreads its rent and head-office costs over more revenue and watches margins widen; one with falling comps sees the same fixed costs eat into a shrinking base, even while it cuts spending.
Target's fiscal 2025 shows the downside. Comparable sales fell 2.6%, the gross margin rate slipped to 27.9% from 28.2% on higher markdowns and purchase order cancellation costs, and the adjusted selling, general and administrative (SG&A) expense rate rose to 20.9% from 20.6%, which Target attributed to the deleveraging impact of lower sales, even though adjusted SG&A dollars fell, according to Target's fourth quarter and full-year 2025 results. The adjusted operating margin fell to 4.6% from 5.2%. This article explains what sits in gross margin, why occupancy and SG&A are largely fixed, how leverage works and how bankers read a margin bridge.
What Sits in Gross Margin
Gross margin is sales less cost of sales, but what counts as cost of sales differs between retailers and consumer products companies, and between retailers themselves.
| Cost | Retailer | Consumer products company |
|---|---|---|
| Product cost | Purchase cost of merchandise | Raw materials, packaging, manufacturing |
| Freight and distribution | Inbound freight; often distribution centers | Inbound and outbound logistics |
| Markdowns and shrink | Clearance discounts, theft and loss | Rarely significant |
| Occupancy | Often included (rent, depreciation of stores) | Not applicable |
| Promotions | Mostly in price | Trade spend deducted from net sales |
A retailer's gross margin therefore reflects its buying, pricing, markdowns and, for many, its store rent. The line-by-line detail, and how different retailers draw the line, is covered in how retailers make money: the retail P&L. For margin analysis, what matters is that the line moves for different reasons in different companies, so bankers always ask which costs sit above it before comparing a gross margin rate across peers.
Markdowns, freight and shrink
Three retail gross margin drivers move more than the rest and appear in almost every margin bridge. Markdowns rise when inventory runs ahead of demand, so they are the first sign of a buying mistake or a weak season; how retailers keep stock in line with sales is covered in inventory turns, GMROI and retail working capital. Freight costs follow container and trucking rates, which can swing sharply with global shipping conditions and tariffs. Shrink, from theft and loss, has become a visible line in recent years: Target cited lower inventory shrink as a partial offset to its 2025 gross margin decline. Because these three are partly cyclical, bankers normalize them over several years before judging a retailer's underlying margin.
Consumer products gross margin
For a brand owner, gross margin is a contest between input costs and the company's ability to offset them through pricing, mix and productivity savings, the steady program of procurement, manufacturing and logistics savings most large staples companies run every year. Colgate-Palmolive's 2025 shows the pieces clearly:
| Colgate-Palmolive gross margin, 2025 (exact, non-GAAP) | Basis points |
|---|---|
| Raw and packaging material costs | -420 |
| Funding-the-growth savings | +260 |
| Higher pricing | +80 |
| Favorable mix | +30 |
| Change in gross margin (60.6% to 60.1%) | -50 |
The company's non-GAAP gross margin fell to 60.1% from 60.6%, according to Colgate-Palmolive's Form 10-K: cost savings and pricing offset most, but not all, of a large rise in material costs. How brands hedge and pass through commodity costs is covered in input cost inflation, hedging and price pass-through.
Occupancy: The Fixed Cost Inside the Margin
- Occupancy Costs
The costs of a retailer's store and distribution space: rent, property taxes, common area charges, utilities and, for owned stores, depreciation. Many retailers include occupancy in cost of sales, reporting a combined "cost of sales, buying and occupancy" line, which makes their gross margin sensitive to sales volume.
Occupancy is largely fixed in the short term: the rent is set by the lease whether the store sells more or less. When comparable sales rise, occupancy falls as a share of sales and gross margin improves; when they fall, it rises. Retailers call this occupancy leverage or deleverage, and it explains why a specialty retailer's gross margin can swing more than its merchandise margin alone would suggest.
The arithmetic is simple. A store selling $5.0 million a year and paying $500,000 in rent carries occupancy of 10% of sales. If its comparable sales fall 10%, to $4.5 million, the same rent becomes about 11.1% of sales, taking roughly 110 basis points off gross margin before any change in pricing or costs. Across a fleet of mall stores in a weak year, that occupancy deleverage alone can erase a year of merchandising gains.
Occupancy and fixed charges
The effect compounds with the rest of the cost base. Rent also feeds into a retailer's fixed charges and its borrowing capacity, which is why lenders and rating agencies treat leases like debt, as explained in lease-adjusted leverage and fixed-charge coverage. Retailers can reduce occupancy only slowly: by negotiating rent at lease renewals, closing or downsizing stores, or subletting space, each of which takes time, so a run of weak comps hits margins well before the cost base can adjust.
SG&A Leverage: Why Comps Drive Margins
Below gross margin, SG&A covers store payroll, head-office costs, marketing, technology and other operating expenses. Much of it is fixed or grows with inflation rather than with sales.
What sits in SG&A
The components behave differently. Store labor is semi-variable: retailers flex hours with traffic, but every store needs a minimum crew to open its doors, and wage rates rise each year regardless of sales. Head-office salaries, technology and rent for offices are close to fixed. Marketing is discretionary, which makes it the line management can cut fastest when sales disappoint, and card processing fees rise with sales. Some retailers also include depreciation and distribution costs in SG&A, so the rate is only comparable across companies once the contents are lined up.
- SG&A Leverage
The improvement in a company's SG&A expense rate, SG&A as a percentage of sales, that occurs when sales grow faster than SG&A dollars. When sales grow more slowly than costs, the rate rises instead, which is called deleverage. Leverage and deleverage are usually reported in basis points.
Because the fixed part of SG&A grows every year, a retailer needs some minimum sales growth just to stand still, and the gap between that rate and actual comps decides whether margins widen or narrow.
The leverage point
Management teams often describe the comp needed to lever SG&A: the comparable sales growth at which expenses hold steady as a share of sales. It depends on wage inflation, rent escalators and planned investment, and it usually sits in the low single digits. That is why comps are watched so closely: as explained in comparable sales: how same-store sales work, they measure exactly the growth that spreads these fixed costs.
Flow-through
Flow-through measures how much of each extra dollar of sales reaches operating profit. A retailer with a 35% gross margin and largely fixed SG&A might keep 20 to 30 cents of operating profit from each additional dollar of comparable sales, far more than its average operating margin of a few cents. The same arithmetic works in reverse, which is why a small comp decline can cut profit sharply, as Target's results show. Bankers estimate a company's historical decremental margin, the profit lost per dollar of lost sales, to stress-test forecasts and debt capacity.
Reading a Margin Bridge
Companies explain margin changes as a bridge from one year's rate to the next, item by item in basis points. Bankers rebuild these bridges for clients and targets, separating structural changes, such as a better product mix or a permanently lower cost base, from cyclical ones, such as commodity swings, markdowns and leverage on sales.
Cost cuts deserve the same scrutiny. Colgate's non-GAAP SG&A rate fell 10 basis points in 2025, helped by advertising falling to 13.3% of net sales from 13.5%. Lower marketing spending lifts margins immediately but may weaken sales later.
In models, bankers build margins from these components rather than from a single rate: merchandise margin, markdowns, freight and occupancy in gross margin; fixed and variable SG&A below it. That structure lets a model show what happens to margins if comps come in two points lower, which is usually the first question a buyer or lender asks.
For a coverage banker, retail margins come down to one question: is the business growing fast enough to outrun its fixed costs, and if not, what is it giving up to defend its margin?
