Two points on the income statement
Both margins divide a profit figure by the same revenue, but they take that profit from different lines of the income statement. Gross profit is revenue minus the cost of goods sold, so the gross margin reflects pricing and the direct cost of producing or buying what you sell. Net income is what remains after everything else as well: operating expenses such as rent, salaries and marketing, plus interest, tax and any one-off items.
An example
A business has revenue of $100,000 and cost of goods sold of $60,000, so its gross profit is $40,000 and its gross margin is 40.0%. Its net income is $12,000, a net margin of 12.0%. The 28 percentage points between the two margins are the $28,000 spent on operating expenses, interest, tax and other items.
The operating profit margin sits between the two: it takes off operating expenses but stops before interest and tax, which helps you see whether the gap comes from running costs or from financing and tax.
When to use which
- Use the gross profit margin to judge pricing and the direct cost of sales, for example after a supplier raises prices.
- Use the net profit margin to see how much of each sale ends up as profit once every cost is paid.
- Track both over time. A steady gross margin with a falling net margin points to costs below the gross profit line, such as overheads or interest.
Summary
| Gross profit margin | Net profit margin | |
|---|---|---|
| Numerator | Revenue minus cost of goods sold | Net income |
| Denominator | Revenue | Revenue |
| Costs taken off | Direct cost of goods sold only | All costs, including operating expenses, interest and tax |
| Answers | How much does each sale earn over its direct cost? | How much of each sale becomes profit? |