Gross and net profit margins

In one paragraph

Gross margin is what is left after making the thing. Net margin is what is left after everything. If the first is healthy and the second is not, your overheads are the problem.

Gross profit = revenue − cost of sales. Cost of sales is the direct cost of the goods or services sold: materials, and the labour that went into them.

Gross profit margin = gross profit ÷ revenue × 100. It measures how well you buy and price.

Net profit = gross profit − all other expenses — rent, salaries, marketing, insurance, interest.

Net profit margin = net profit ÷ revenue × 100. It measures the whole business.

Reading the pair together

This is where the insight is. A falling gross margin means the problem is upstream: you are buying badly, discounting too hard, or your costs rose and your prices did not. A healthy gross margin with a weak net margin means the problem is downstream: your overheads are too heavy for the sales you make.

Two businesses with identical net margins can need completely opposite fixes. Only the pair tells you which.

How to actually use it

• Track both monthly, not annually. Gross margin drifting down by a point a month is invisible in a year-end account and obvious in a monthly one.
• Compare with your own history first and the industry second. The trend in your own numbers is more actionable than a benchmark from a different business.

Where it breaks down

• Margins say nothing about cash or about volume. A superb margin on almost no sales does not pay wages.
• What sits in 'cost of sales' versus 'overheads' varies between businesses, which makes cross-company comparison less reliable than it looks.

If you are being examined on it

State the formula, calculate, then say which of the two moved and what that implies. The interpretation carries the marks.

More on finance & accounting