Gross margin and net margin are both measures of a business’s profitability as a percent of revenue. However, where gross margin only considers revenue and cost of goods sold, net margin considers all other costs that are used to calculate a business’s net profit.
Gross margin and net margin also answer different questions. Business owners need to understand both in order to know whether their business is growing profitably.
What Is the Difference Between Gross Margin and Net Margin?
Gross margin measures the percentage of revenue remaining after direct costs of producing or delivering products and services. Net margin measures the percentage remaining after all expenses, including operating costs, interest, and taxes.
Gross margin helps evaluate pricing and delivery economics. Net margin evaluates the profitability of the entire business.
How To Calculate Gross Margin
Gross margin is calculated by subtracting cost of goods sold from gross revenue and dividing the resulting number by gross revenue. The result is expressed as a percentage.
Gross Margin = (Revenue − Cost of Goods Sold) ÷ Revenue × 100
Here’s an example: Suppose a business generates $1 million in revenue and incurs $500,000 in cost of goods sold. In this case, gross profit (revenue minus cost of goods sold) is $500,000 and gross margin is 50%. That remaining amount must cover operating expenses and other costs before any net profit remains.
In these calculations, cost of goods sold may include merchandise, materials, manufacturing labor, or direct service labor, depending on the business and accounting policies.
How To Calculate Net Margin
Calculating net margin is even easier than calculating gross margin. In this case, you subtract all costs from gross revenue. The result represents a business’s net income. To determine net margin, divide net revenue by gross revenue.
Net Margin = Net Income ÷ Revenue × 100
Consider the same hypothetical business above. Assume the business has $380,000 in operating expenses and $40,000 in interest and taxes. After subtracting these additional expenses from gross revenue, the business has $80,000 in net income. This represents an 8% net margin on the business’s $1 million in revenue.
Which Matters More: Gross Margin or Net Margin?
Neither gross margin nor net margin is necessarily more important as a measure of a business’s profitability. Both measures are important in different contexts. Gross margin can help business owners evaluate pricing, input costs, product mix, and service delivery. Net margin, on the other hand, can help evaluate a business’s entire cost structure, including overhead and financing costs.
The relationship between gross and net margin is especially informative. For example, if gross margin holds steady while net margin declines, business owners should investigate overhead and other below-gross-profit costs to look for increasing costs. If both decline, pressure may be coming from multiple parts of the business.
How Revenue Growth Can Hide Declining Margins
Revenue growth doesn’t always translate into higher profits. When costs rise faster than sales, a business can experience margin compression, meaning it retains less profit from each dollar of revenue.
This has been particularly common in certain industries over the past 30 years as technology has forced businesses to charge less per client. In many cases total revenue is up because these businesses have more clients than they did 30 years ago, but their costs have risen in line with their increased clientele but revenue per client has declined.
Here’s another hypothetical: Imagine a business increases annual revenue from $1 million to $1.3 million. However, its gross margin falls from 50% to 42%, while operating expenses rise from $380,000 to $450,000. Despite generating an additional $300,000 in revenue, gross profit increases by only $46,000, and operating profit actually declines from $120,000 to $96,000.
This is why growing businesses need to monitor gross margin and operating profit alongside revenue growth. Higher sales don’t necessarily mean better financial performance, particularly when rising costs, discounting, or changes in product mix erode profitability.
Five Places to Look When Gross Margin Declines
1. Pricing
Consider whether customers are paying less for the same products or services. Examine realized prices, discounts, promotions, and contract terms.
2. Product and Customer Mix
Investigate whether revenue has shifted toward lower-margin offerings or customers. Compare gross profit by product, segment, and channel.
3. Direct Labor
Are wages, overtime, or subcontractor expenses growing faster than output? Examine utilization and labor hours per engagement.
4. Materials and Supplier Costs
Check input prices, freight, or purchasing practices to see if any have changed. Separate price increases from changes in quantities consumed.
5. Delivery Costs and Complexity
Custom requests, rework, small orders, or inefficient processes may be making each sale more expensive to fulfill.
What Is a Good Gross Margin or Net Margin?
There is no universal benchmark for what constitutes a good gross margin or net margin. Different industries all have different cost structures and, in many cases, different industries have different thresholds that are considered strong. If you want to know what constitutes a good gross margin or net margin, compare results of businesses within your particular industry.
Don’t Confuse Profit Margin With Cash Flow
Another increasingly common problem in business is that businesses can report net income while still running short of cash. In many cases this is because customers haven’t paid, increased inventory absorbs cash, or debt principal comes due. When reviewing these indicators it’s important to remember that profits and liquidity may be related but are still distinct metrics.
How Often Should You Review Margins?
Most small businesses should review their margins on a monthly basis. Typically it makes sense to review these figures when closing out the monthly books for a business. It may also be a good idea to compare current results with prior periods as well as forecasted figures. If you find that your numbers have deviated from what you expected, ask which costs, products, and customers explain meaningful changes—and what decisions those changes justify.
The Bottom Line
Gross margin is a financial metric that explains the economics of what a business sells. Net margin explains the profitability of the business as a whole. While it’s important to calculate both of these metrics and track them over time, neither should be considered in isolation.
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