A company’s financial statement has all the financial information required to analyse its financial health. Experts, analysts, investors or lenders use this information to understand a company’s performance. Thus, they interpret this information with different financial tools and methodologies. One such methodology is the profitability ratio that helps measure the company’s profit against its revenue. The profitability ratios are gross profit margin ratio and net profit margin ratio. In this article, we discuss the difference between gross margin vs net margin.
What is Gross Profit Margin?
Gross Profit Margin helps measure the company’s profit from its total sales after deducting the direct costs or cost of goods sold. It is a simple metric to evaluate how efficiently the company manages its labour and raw materials during the production process and generates profits.
The company’s income statement calculates the gross profit after deducting the cost of goods sold from the total sales. However, the cost of goods sold is considered only direct costs and not indirect costs. In other words, direct costs are all the expenses directly related to the company’s core operations. The following is the formula to calculate the gross profit margin –
Gross Profit Margin = (Net Sales – Cost of Goods Sold)/ Net Sales OR
Gross Profit Margin = (Gross Profit/ Net Sales) x 100
What is Net Profit Margin?
Net profit margin is a financial ratio that helps to measure the company’s profitability from its total revenue (total sales). However, net profit is calculated by deducting all the expenses like operating costs, interest and taxes from the gross profit. Therefore, the net profit margin ratio determines how much profit a company makes against one rupee of its revenue.
The net profit margin ratio helps to understand the financial stability of a company. Even though both gross profit margin and net profit margin shows the company’s profitability. Thus, the former is derived by deducting the cost of goods sold from total sales and the latter is computed by deducting all expenses and obligations from total sales. As a result, the company’s gross profit is always higher than the net profit. The following is the formula to calculate the net profit margin.
Net Profit Margin Ratio = (Net Income/ Net Sales) x 100
Gross Profit Margin vs Net Profit Margin
The following are the differences between gross margin vs net margin.
|Parameter||Gross Margin||Net Margin|
|Income Statement Location||Gross profit is in the middle of the income statement, immediately after the cost of goods sold.||After all, net profit is at the end of the income statement, expense line items.|
|Size||The gross profit margin is always higher than the net profit margin because it does not include operating expenses (selling and administration expenses).||Net profit margin is always lower than the gross profit margin as it deducts all operational expenses, interest and tax.|
|Tax||Gross profit margin does not include any income tax expense.||Net profit margin has to include the effect of income tax.|
|Type of costs||It includes a proportion of direct expenses, i.e. directly related to the production process. Usually, they are variable costs.||It includes all the company’s expenses, like selling and administration expenses. Usually, they are fixed costs.|
Both gross profit margin and net profit margin are critical to assess the company’s financial health. Both are to be watched closely on a trend line, and any deviation may trigger an investigation by the management.
How to Calculate Gross Margin and Net Margin?
Calculating the gross profit margin and net profit margin is very easy as they are separate line items in the periodic income statement. Firstly, to calculate the gross profit, the following direct costs shall be deducted from the total sales.
- Cost of goods sold
- Raw materials cost
- Cost of labour
- Production expenses
After arriving at the gross profit, calculating net profit becomes simple. The following are the other expenses that shall be deducted from the gross profit –
- All operating expenses like administration and marketing expenses
- Any other expenses incurred during that period
Note: In the case of total sales, to get a more accurate calculation, it is better to consider net sales because it is calculated after adjusting total sales against discounts, returns, allowances etc.
Let us understand the gross margin and net margin calculation with the help of an example.
The following table shows the income statement of an ABC company for the financial year 2020 – 2021
|Particulars||Amount (in Rs.)|
|Cost of Goods Sold||1,65,000|
Gross Profit Margin = (610,000/8,00,000) x 100
Gross Profit Margin = 0.7625 or 75.25%
Net Profit Margin = (145,000/8,00,000) x 100
Net Profit Margin = 0.18125 or 18.12%
How to Interpret Gross Margin and Net Margin?
Both gross profit margin and net profit margin are crucial in measuring the company’s profitability and efficiency in cost management. Also, it is essential to assess these financial metrics as it helps it know its financial health. Furthermore, a higher profit margin indicates that the company efficiently manages its production costs and other expenses. On the other hand, a lower profit margin signals the company to evaluate its production costs, pricing strategy or other expenses to increase its profitability.
The gross profit margin indicates the relationship between the total costs a company incurs against its total revenue. In contrast, the net profit margin shows a detailed understanding of the company’s cost management efficiency.
These metrics can be used to compare companies with varying market capitalisation within the same industry. Also, using both these metrics together provides an understanding of how efficiently the company is managing its costs and obligations not directly related to production. Moreover, it is wise to compare these margins of the company within the same industry and over multiple accounting periods to understand the trends.
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