Gross Margin vs Net Margin in Accounting

Understanding gross margin vs net margin is essential for anyone analyzing a company’s profitability or financial health. Both are profit metrics, but they measure different aspects of a business’s performance.

Gross margin shows how efficiently a business produces or delivers its products, while net margin reflects the bottom-line profit after all expenses. Knowing the difference helps business owners, investors, and financial professionals make more informed decisions and identify areas for improvement.

What Is Gross Profit Margin?

Gross profit margin shows the percentage of revenue that remains after accounting for the cost of goods sold (COGS). This metric reflects how efficiently a company produces and sells goods overall. Its more general focus differentiates gross profit margin from other metrics like contribution margin, which is more often used for per-unit analysis.

A high gross profit margin shows strong control over production costs or a strong pricing strategy. Low margins suggest inefficiencies or intense competition in your industry. Many small business owners consult small business accounting professionals to help them improve this percentage.

Why Is Gross Profit Margin Important?

Gross profit margin is important as it shows how efficiently a company produces or delivers its products or services. This is useful for internal decision-making as it helps detect rising costs, informs pricing and cost strategy, and lays the groundwork for total profitability.

What Is Net Profit Margin?

Net profit margin shows a company's overall profitability, or net income, after all its expenses have been deducted. Business expenses include COGS, operating expenses, interest, taxes, and depreciation. This figure tells you how much of each dollar in revenue translates into profit.

Net profit margin is commonly referred to as a company's "bottom line." A strong net profit margin indicates that the company generates revenue and manages its COGS and operating costs efficiently.

Why Is Net Profit Margin Important?

A healthy net profit margin indicates that a business manages its production costs and overheads effectively. This makes it an important metric for attracting potential investors, evaluating sustainability, and comparing to competitors.

How to Calculate Gross Profit Margin

Calculating gross margin involves subtracting the COGS from your total revenue. Divide the result (the gross profit) by total revenue and multiply by 100 to express it as a percentage:

Gross Profit Margin = (Revenue - COGS) / Revenue x 100

This formula relies on other key financial metrics like revenue and COGS. Revenue includes:

• Sales of products or services

• Sales-related fees

COGS includes:

• Raw materials

• Direct labor

• Manufacturing costs

• Inventory purchases

• Packaging

Example

Let's imagine a soft furnishings manufacturer based in Jacksonville, Florida. They want to calculate gross profit from the previous year with the following results:

• Overall revenue: $500,000

• COGS: $210,000. This includes:
  - Fabric and materials: $120,000
  - Labor (sewing): $80,000
  - Packaging for the soft furnishings: $10,000

In this case, their gross profit is $500,000 - $210,000 = $290,000. 

They will then calculate gross profit margin. Gross profit divided by overall revenue x 100 will give this result as a percentage.
($290,000 / $500,000) x 100 = 58%

This business retains 58 cents from every dollar after covering direct production costs.

How to Calculate Net Profit Margin

Calculating net profit margin involves dividing net profit by revenue and multiplying by 100:

Net profit margin formula: Net Profit Margin = (Net Profit / Revenue) x 100

Net profit takes into account all the direct and indirect expenses a business incurs, such as:

• COGS

• Operating expenses (rent, utilities, salaries, marketing costs...)

• Depreciation and amortization

• Loan interest payments

• Business insurance

• Taxes

• Admin or overhead expenses

Example

The same soft furnishings company from the previous example also wants to calculate its net profit margin. Their figures for the previous year were:

• Revenue: $500,000

• COGS: $210,000

• Operating expenses: $110,000
  - Rent: $30,000
  - Salaries: $50,000
  - Marketing: $20,000
  - Overheads: $10,000

• Depreciation: $5,000

• Loan interest: $8,000

• Taxes: $12,000

Step 1: Calculate total expenses

Total expenses = COGS + Operating Expenses + Depreciation + Interest + Taxes (=$345,000)

Step 2: Calculate net profit

Net Profit = Revenue - Total Expenses (= $500,000 - $345,000 = $155,000)

Step 3: Calculate net profit margin

Net Profit Margin = ($155,000 / $500,000) x 100 = 31%

This means for every dollar the company makes in revenue, the business earns 31 cents in net profit after all expenses are paid.

How to Interpret Your Gross Margin

Your gross margin is most useful for evaluating the profitability or efficiency of different parts of your business. It also reveals how your company manages direct costs relative to your revenue.

In high-margin industries like software or luxury goods, gross margins may reach 60–80%. In most industries, a gross margin of 30–50% is strong. A figure in this range shows you're generating strong profits from your core offerings. You also likely have highly cost-efficient production or great pricing power in the market.

A low profit margin is below 30%. This shows your production costs are too high, or you may be underpricing your products. A low profit margin should also be a sign to check for inefficiencies in sourcing, labor, or inventory management.

Use a lower-than-expected gross margin to:

• Adjust pricing strategies

• Negotiate better deals with your supplier

• Streamline production processes

• Evaluate the profitability of each product or service you offer

How to Interpret Your Net Margin

A high net margin is generally considered 15-25% or more. A high net margin shows you're selling efficiently and keeping your costs under control. Your business shows excellent financial health and is likely scalable.

However, a low net margin (under 10%, or even negative) indicates overspending. This could be on operations, marketing, or overheads. In other cases, high debt or tax burden could impact net margin. Low net margin may also indicate that the business is vulnerable to cash flow issues. Use a low figure to make immediate changes, like:

• Exerting better control over fixed costs and overhead

• Optimizing operations where possible for improved profitability

Remember that conducting this analysis in isolation gives a very limited picture of your financial health. For example, a company that reports solid profits on its profit and loss statement could still have negative cash flow if it's not effective in collecting on credit sales. This metric therefore only offers the whole picture when used in conjunction with other documents like the cash flow statement.

Track trends over time to gain a clear understanding of your company's financial health and identify performance patterns. It's also important to compare your margins with those of other businesses within your industry. A good margin for a retail store is typically different from that of a tech company.

FAQs

Can a company have a high gross margin but a low net margin?

Yes. A business can be highly efficient at producing its goods or services, but still have high costs that reduce its net profit margin.

What is a good gross profit margin?

A good gross profit margin varies according to industry. Retail companies consider 20-40% a strong figure, while software or tech companies look for 70-90%.

What is a healthy net profit margin?

A healthy net profit margin also varies according to industry. Averaging industry-specific benchmarks published in The Finance Weekly, 5-10% is generally considered average, 10-20% is good, and above 20% is excellent.

Make Smarter Decisions With Margin Analysis

Gross margin and net margin are both vital for understanding how your business earns, spends, and ultimately profits from its operations. While gross margin highlights efficiency in production, net margin reveals overall financial health after all costs are considered.

Together, they offer a more complete picture of profitability when analyzed over time and compared within your industry. Businesses will make smarter strategic decisions, improve performance, and achieve sustainable growth by tracking both metrics.