A profit margin is a percentile of profit that indicates the sum an enterprise earns for every dollar of sales, which means a company will get a higher profit margin if it makes more cash per sale.
However, net profit margin and gross profit margin are two different profitability ratios used by a company to evaluate its financial stability and general condition.
Gross profit margin is the revenue percentage that surpasses the cost of goods sold (COGS). An enterprise realizing profits above its costs will register a high gross profit margin.
A company’s net profit margin is the net profits to revenues ratio which shows how much every revenue dollar becomes profit.
Understanding the Two Profit Margins
What is Gross Profit Margin?
Gross profit margin is a profitability measure that indicates the revenue percentage that surpasses COGS. It shows how a firm’s executive management body successfully generates revenue given the cost of processing its services and products. The greater the figure, the more efficient the organization is in making a profit for each dollar of cost used.
COGS is the sum used by an enterprise to produce its products and services. You can calculate the gross profit margin by subtracting the COGS from the total earnings then dividing the difference by total earnings. The result is then multiplied by 100 to get the percentage.
What is Net Profit Margin?
A net profit margin is a company’s net profits to revenues ratio. It’s calculated as a percentage and indicates how much every dollar earned translates to profit.
It’s crucial to calculate the net profitability since not all increases in revenue translate to increased profitability. The net profit is gross profit (earnings minus COGS) minus operating cost and other expenses like taxes and debt interest.
The net profit calculation may seem a bit complex, luckily, it’s always calculated for us and indicated as net income on the income statement.
Key Differences Between Gross and Net Margins
The differences are:
- Tax effect—The net margin includes the income taxes effect, whereas the gross margin isn’t net income tax expenses.
- Size—The gross margin is usually higher than the net since it doesn’t include administrative and selling expenses.
- Cost inclusions—The gross margin includes a significant percentage of variable expenses, plus the direct materials required to make sales. The net margin has a lower percentage of varying expenses because it includes administrative and selling costs, which are fixed expenses.
- Income statement position—The location of gross margin is halfway down the income statement, just after the cost of products sold line item. The net margin is placed at the bottom of the income statement, after all the expense line items.
The net margin and gross margin are vital to a business’s financial health—watch them closely on a trend line. A slight fall in either will probably require a comprehensive inquiry by management.
Gross Profit vs. Net Profit Margins
It’s crucial to note that the gross profit and gross profit margins differ. Gross profit is a total dollar amount, while the gross profit margin is expressed as a percentage.
Creditors learn more about your business health and the cash available from net profit than they do from gross profit. Investors will refer to your business’s net profit to confirm if it’s prudent to invest their funds.
Acknowledging gross profit trends will help you devise ways to reduce the cost of products sold or increase the prices of your goods. If your net profit is more than gross profit, you must minimize your expenses.
To create a financial statement and an income statement that demonstrates your business’s financial health, you must know the accurate net and gross profit values.
Not knowing how to differentiate net and gross profit might lead to having incorrect financial statements and may also paint an inaccurate picture of how your business is fairing.
Primary financial documents assist stakeholders in making major business decisions. Therefore, decision-making will be affected if the statements bear inaccurate profit details.
How to Calculate Gross Margin
You have to calculate gross profit before you compute the gross margin. However, many organizations usually list it as a different entity in their periodic income reports.
Nonetheless, some items should be deducted from the total revenue to compute gross profit. These items include:
- Labor cost
- Cost of production
- Stock consumed
- Register maintenance costs
In essence, all the costs directly associated with the central business operations are considered gross margin. This is the major difference between net margin and gross margin.
After working out gross profit, you can calculate its ratio using:
Gross margin = (Gross profit / Total revenue) x 100
How to Calculate Net Margin
Before you derive the net margin, you need to calculate the net profit. However, just like gross profit, net income is also listed as a separate entity in financial statements.
Items that are usually subtracted from the income to compute net income include:
- Revenue cost
- General and administrative overhead
- Cash outflows for specific time frame per accounting standards
- Interest in arrears
You can also calculate net profit margin from gross profit by subtracting each item listed above to cut back on the price of goods sold. It’s important when factoring in net profit vs. gross margin. Nonetheless, you can also calculate net margin using:
Net margin = (Net income / Total revenue) x 100
Keep in mind that total income can be recorded as complete net sales in particular financial statements. In such instances, it’s computed after calibrating entire sales versus allowances, discounts, etc.
How to Interpret Gross Margin and Net Margin
Net and gross margins are important gauges of a company’s competency and profitability in expenditure control. This is because gross margin indirectly links main running costs and total income. It assists organizations in analyzing if they are managing costs vs. income well.
As an important indicator of the net vs. gross margin, the former symbolizes the association between an organization’s full costs versus its real income. Net margin gives a more wholesome comprehension of a company’s budget control efficiency.
Moreover, on the same grounds, both net and gross margins can be utilized as a gauge for comparing organizations with different rankings of capitalization in the same field. Using net margin and gross margin gives a grasp of how structures organizations handle obligations and costs not directly linked to production.
Limitation of Gross and Net Margin
One disadvantage of these standards is that they can’t be utilized in contrasting organizations in different fields as the average differs. In addition, simply focusing on comparing the two margins does not equate to doing a thorough financial assessment.
Accordingly, people may also use operating income together with gross and net margin to make out an organization’s credit leverage.
Frequently Asked Questions
1. Which Is Greater Gross Profit Margin or Net Profit Margin?
The profit margin is always more significant than the net margin. This is because the profit margin doesn’t include administrative and selling expenditures. Income tax costs don’t affect the gross margin but the net margin.
2. What’s the Difference Between Net and Gross?
Gross income refers to an employee’s earnings before deductions such as benefits and taxes. Net income is the money employees get after the deductions have been made.
3. What Is A Good Gross Profit Margin?
An ideal profit margin will differ significantly depending on the industry. However, a ten percent margin is deemed average in most industries, while a twenty percent net profit margin is good. A five percent margin is considered low.