What’s the difference between Gross Margin (GM) and Net Margin (NM)? They are derived from the Gross Profit (GP) and Net Profit (NP) calculations. Let’s see how this is done and how they vary.
What is Gross Margin?
Gross margin, also known as operating margin, is the percentage left over after the variable costs of production are subtracted from revenue.
Net Sales – Cost of good sold (COGS) = Gross Profit (GP)
For example, if you buy 100 widgets for $700 and sell all of them for $1,000 you have a GP of $300 without accounting for any other expenses.
1,000-700 = 300
Gross Margin (GM) reports a percentage rather than actual numbers so it is calculated like this:
Gross Profit / Net Sales expressed as a percentage. 300/1,000 x 100 = 30%
That means instead of saying we have $300 GP as above we would say we have a GM of 30%. It represents the amount of profit from each dollar. A GM of 30% means that for each $100 in sales the company netted $30 GP.
What is Net Profit Margin?
The Net Profit (NP) and corresponding Net Margin (NM) is the net amount left after subtracting the remaining costs. This Net Profit is often referred to as the “bottom line” because it can be found at the bottom of a profit and loss statement and it is the net of total income and total expenses. It then tells us how much profit was left after paying all of the expenses
Often referred to as operating costs, they include things like rent, utilities, labor, insurance etc. Of course, whether some of these things are added to COGS or are all operating costs depends on what type of business (manufacturing, service, sales…) is being reported for this example we will assume it is all operating expenses.
The NP is calculated as GP minus operating expenses.
So if the example above had $150 in operating expenses the NP would be calculated as: 300 – 150 = $150
Net Margin (NM) is the net profit expressed as the percentage of revenue.
NM = NP / Net Sales
In our example the NM would be: 150 / 1000 * 100 = 15%
Gross Margin Vs Net Margin
Why use margins?
Converting to a percentage is sometimes called common-sizing and it allows anyone to quickly compare companies of different sizes or the same company to different time periods when there has been a substantial change is sales.
Comparing these margins to different time periods can give you some insight into where you may be able to improve your business. Here are some examples:
If it is going down then the cost of your products or services you sell are going up or your prices are going down. After reviewing your pricing, look at your costs and consider these options:
- Purchase in bulk to get a better price for both purchase and shippingLook for alternative sources for products
- Offer to pre-pay for orders to get better pricing from suppliers
Even with limited local storage, you may be able to negotiate a better price if you commit to a large order that is to be delivered over a longer period of time.
If GM is stable then NM goes up as you gain operating efficiency. If down, examine operational costs such as:
- Appropriate staffing and wages
- Efficiency of processes and systems
- Bottlenecks and unbalance production lines that are causing delays
- Inefficient use of resources like wasted supplies
- Errors causing work to be re-performed (it’s cheaper to do it right the first time)
- Out-of-date equipment that could be replaced with newer, more efficient models
Read about the difference between Cash Flow and Profit
Of course, every business has unique challenges and obstacles to overcome and this information is presented as a general overview. Your business probably has some unique features and characteristics that should be considered during your analysis.
Our Tulsa CPAs along with our Oklahoma City CPAs want to help you make and keep more of YOUR money. Find out more today by contacting one of our offices in OKC: 405-720-1244 or Tulsa: 918-477-7650.