A company’s income statement contains two important financial metrics that business owners should be tracking: gross margin and profit margin. These metrics measure profitability, and they indicate a company’s financial health and whether it’s trending upward, trending downward or treading water.
Here’s what gross margin vs profit margin means and how you can use these metrics to grow your business.
What Is Gross Margin?
Gross margin measures how efficiently management uses its production costs to make a company’s products or services. It divides your gross profit — the income from your sales minus the costs of goods sold (the sum of direct labor costs, direct materials costs and shipping expenses) — by your sales, then expresses that figure as a percentage using this formula:
Gross Margin = ((Sales − Cost of Goods Sold) ÷ Sales) × 100
As an example, let’s look at a fictional company we’ll call Joe’s Plumbing and Heating. Its latest yearly income statement shows the following:
- Sales: $1,300,000
- Labor: $522,600
- Materials and shipping: $257,400
- Gross profit: $520,000
Using our formula, Joe’s Plumbing and Heating’s gross margin would be 40%:
Gross Margin = (($1,300,000 − ($522,600 + $257,400)) ÷ $1,300,000) × 100 = 40%
What Is Profit Margin?
Profit margin measures how efficiently management has generated profit. Also called net profit margin (and often referred to as the bottom line, Investopedia says), it’s a measure of how much profit is generated by a company’s sales. It’s based on net profit, or how much a company makes after accounting for operating expenses (cost of goods sold, general and administrative expenses, loan interest and taxes).
The formula for calculating profit margin is:
Profit Margin = ((Gross Profit − (General and Administrative Expenses + Interest on Loans + Taxes)) ÷ Sales) × 100
Let’s take the following data from Joe’s Plumbing and Heating’s income statement:
- Gross profit: $520,000
- General and administrative expenses: $300,000
- Interest: $36,000
- Taxes: $80,000
- Net profit: $104,000
Using our formula, we can calculate Joe’s Plumbing and Heatings’s profit margin at 8%:
Net Profit Margin = (($520,000 − ($300,000 + $36,000 + $80,000)) ÷ $1,300,000) × 100 = 8%
Gross Profit vs Gross Margin: Increasing Income
So now we know that Joe’s Plumbing and Heating has a gross profit margin of 40% and a net profit margin of 8%. These numbers will help Joe and his team set their financial goals for the coming year and formulate a plan to reach them.
Suppose Joe wants to increase his net profit by $36,000 to $140,000. What changes would Joe need to make? Here’s one possible course of action.
- Pursue a more aggressive sales plan. Increasing sales by $50,000 would add $20,000 to Joe’s gross profit, assuming he maintained the same gross margin of 40%. That’s only a 3.8% increase in sales.
- Cut overhead. Trimming expenses by 4% — reducing $300,000 to $288,0000 — would add $12,000 to the net profit. It shouldn’t be too hard to go line by line and find a few expenses to cut.
- Assess debt options. Joe could also negotiate with his lenders to lower his interest costs by about $4,000. As a trade-off, though, he might have to agree to keep higher balances with the bank. Or, if his current bank won’t lower his interest, he might have to search for a more competitive lender.
If he took all of these actions, Joe could increase his net profits by $36,000 and up his net profit margin to 10.4 % ($140,000 ÷ $1,350,000 = 10.4%).
Developing Strategies Using Gross Profit, Gross Margin and Profit Margin
You can use your current gross margin and profit margin as starting points to set your financial goals and then analyze your income statement to figure out how to get there. Our example above is just one of many possible pathways. With your experience and imagination, you can choose the one that best fits your profit objectives.