Small businesses fuel much of America’s economy, and many of their owners are in turn fueled by a deep passion for the services they provide. But passion alone doesn’t pay the bills, as they say—and accounting metrics are a critical piece of understanding whether your business is in good standing. Two of these crucial figures are gross margin and net margin, a pair of key profitability ratios that help determine a company’s financial health. Ahead, learn more about the importance of each one and how they’re used.
What is gross margin?
Gross margin, sometimes referred to by its full name, “gross profit margin,” measures how much money your business has left over after accounting for the cost of producing the goods and services you sell.
Gross margin usually is expressed as a percentage. If your gross margin is, for example, 25%, that means your business retains 25¢ for every dollar of revenue.
This metric is important because it measures your business’s potential to make a profit under current pricing conditions, showing whether you can make money given how much it costs to produce your product or service and how much you’re selling it for to customers. Gross margin can also help businesses respond to changes in labor and material costs over time.
You can calculate gross margin with this formula:
[(total revenue - cost of goods sold) / total revenue] x 100 = gross margin
As you can see, this is a simple ratio that is calculated using two metrics. Total revenue (also called net sales) is gross revenue minus any returns or discounts on what you sell. Cost of goods sold (COGS) represents any production costs including materials and labor. Both of these metrics are included on a company’s profit and loss statement or income statement, which is a financial statement that shows a company’s net income over a given reporting period, such as a quarter or a year.
Here’s an example: Let’s say a boutique jeweler generated $32,000 in total sales revenue for the fourth quarter, with production costs adding up to $14,000. The net margin formula would be:
[($32,000 total revenue- $14,000 COGS) / $32,000 total revenue] x 100 = 56% gross margin
The jewelry business retained 56¢ for every $1 of revenue during the quarter.
If a business is not generating as much profit as it needs, calculating gross margin can help identify production costs or pricing choices that could be the source of the problem.
What is net margin?
Net margin, also known as net profit margin, accounts for all business expenses in a given period. This includes the cost of goods sold (COGS), but also operating costs like rent and administrative expenses, taxes, depreciation, and, when applicable, non-operating expenses or revenue such as inventory write-downs or one-time payments.
The net profit margin formula simply adds those additional expenses to the gross margin formula. To calculate net margin:
Because net margin tallies up every bit of expenses and gross margin considers only COGS, net margin is almost always lower than gross margin (the opposite would happen only in rare cases, like a big non-operating windfall, such as damages awarded in a legal case). Though both metrics are important, net margin provides more meaningful and holistic insight into your business’s financial viability and fundamental profitability.
Gross margin vs. net margin: key similarities and differences
Gross and net margin are both important profitability metrics for small business owners to track, and they are calculated using similar formulas. But net margin accounts for additional expenses (and one-time inflows or outflows where applicable) to provide a fuller picture of profitability, while gross margin focuses solely on the cost of goods sold.
Profit margin formulas
- How they’re similar: Gross margin and net margin are profitability ratios usually expressed as percentages, and each takes into account both revenue and costs.
- How they’re different: The gross margin formula is more basic, because it simply subtracts the cost of goods sold from the total revenue generated, and then divides that figure by the total revenue. Net margin uses the same formula, except in the first half of the equation it adds several line items to subtract all business expenses from total revenue—including not only COGS but also tax liabilities, rent payments, depreciation, and any other operating or non-operating expenses in a given period.
Information they provide to small businesses
- How they’re similar: Both gross and net margin are key metrics for small business owners and provide crucial information about profitability.
- How they’re different: Gross margin shines a bright light on the cost of goods sold, because that’s the only figure the formula subtracts from total revenue. It offers a key insight into the core business and may help business owners home in on factors within their control, such as the price the business charges for its goods or services. Gross margin provides a sense of the potential profitability of the business in current pricing conditions. Net margin, by contrast, is almost always a lower number because it accounts for every business expense when subtracting costs from total sales. This metric offers a fuller picture of the company’s profitability.
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Gross margin vs. net margin FAQ
Why is net profit margin “better” than gross profit margin?
Both metrics can be useful to small business owners, but net profit margin comes closer to encapsulating a company’s financial health in a single figure. That’s because net margin takes into account total expenses, including cost of goods sold, operating expenses such as rent payments, taxes, depreciation, and any other costs. Gross margin considers only the cost of goods sold, which is helpful for informing pricing and assessing production costs but doesn’t account for all expenses.
Can net margin be higher than gross margin?
It’s possible but unlikely: Net margin tallies up all expenses and one-time factors, while gross margin considers only the cost of goods sold, which amount to just some of a businesses expenses. For net margin to be higher, it would generally require an unusual one-time influx of cash—such as a damages award in a legal case—that offsets all non-COGS expenses, and then some.
Can a net profit margin be too high?
Generally speaking, higher profit margins are better because they mean a company is efficiently managing its costs and generating sales. (One caveat: If your prices are so high that your margin seems excessive, a competitor might have an opportunity to swoop in and undercut you.) What qualifies as a “good” margin varies by industry, however, so make sure you’re taking that into consideration when comparing your metrics to another company’s.
Gross means all of something, while net is what remains of that whole after deductions. Consider a paycheck: Gross pay is what you earn before deductions, while net pay is what you receive after taxes, health care premiums, 401(k) contributions, and other withholdings. When talking about profit margins, gross margin measures how much money your business has left over after accounting for the cost of making goods and services (COGS) you sell, while net margin considers not just COGS but all expenses such as tax liabilities and administrative costs.
