Are you making enough money to stay in business? And are there ways to increase your profitability?
As a finance leader, you know these are critical questions, and that tracking your profit margins, and specifically your Gross Profit Margin and your Net Profit Margin, will help you answer them.
What is Gross Profit Margin and Net Profit Margin?
First, it’s important to understand the difference between gross profit vs. net profit. Your Gross Profit Margin is a percentage derived from an equation that shows the amount of money available after taking your total revenue and subtracting the cost of goods sold (COGS) or the amount it cost your company to produce the goods or services that it sells.
Gross Profit Margin is also referred to as Gross Margin or Gross Profit.
Your Net Profit Margin is also a percentage derived from an equation that shows what cash remains from your gross profit (revenue minus cost of goods) after your operating expenses and all other expenses, such as taxes and interest paid on debt have been deducted.
Net Profit Margin is also called Net Profit or Net Income.
“Income,” “profit,” and “margin” are sometimes used in place of each other, but it’s important to remember that “income” and “profit” refer to monetary amounts, whereas “margin” refers to a percentage.
Why is Gross Profit Margin important?
“One of the most important financial concepts you will need to learn in running your new business is the computation of gross profit.”
Knowing your Gross Profit Margin helps you measure and understand how efficiently your company uses its raw materials and labor to produce the goods/services it offers and also track profitability trends. Tracking profitability trends is important because many businesses have gotten into financial trouble by having an increasing gross profit but a declining Gross Profit Margin.
For example, a company earns $500,000 of revenue and $375,000 of gross profit. Say in a year it doubles revenue to $1 million and increases gross profits to $600,000. The initial response could be, “Awesome! We’ve doubled revenue and almost doubled gross profits!” However, if they don’t look at the margins, part of the story could go untold.
In this example, when the company generated $500,000 of revenue and $375,000 of gross profit, they had a Gross Profit Margin of 75% (375,000 / 500,000 = .75). When they doubled revenue to $1 million and increased gross profits to $600,000 their Gross Profit Margin decreased to 60% (600,000 / 1 mil = .6). That is a 15% decrease in gross profit which means there is less money to cover all of their other expenses which will also be growing as they work to increase revenue.
If this trend continues, the business will quickly get into financial trouble.
Calculating your Gross Profit Margin also lets you compare your margin to the industry standard to see how you match up with similar companies. The answer will help you know if you need to alter how you do business to stay competitive.
When comparing your margin to other companies, keep in mind that Gross Profit Margins vary widely from company to company (startup or long-established) and industry to industry. On the high end of the margin spectrum, companies in the financial sector have been known to have Gross Profit Margins as high as 80-90%. On the lower end of the margin spectrum, companies in the retail industry have been known to have Gross Profit Margins around 20%.
Why is Net Profit Margin important?
If you’re looking to track and increase the profitability of your company, you’ll also want to know how to calculate Net Profit Margin.
To increase your profitability, you basically need to increase revenue, reduce costs, or a combination of the two. Knowing your Net Profit Margin creates a clearer picture of overall company expenses compared to revenue and helps you work to achieve either of those goals.
If you’re in a competitive market, reducing costs can be the easier route to take to increase profitability.
Another reason your Net Profit Margin is important to track is because an increase in revenue doesn’t always equate to an increase in profitability.
Your Net Profit margin helps you focus in on the final financial result of your company’s efforts to create and sell products or services. And it takes all of your expenses into account to help you see an overall picture of company finances.
Your Net Profit Margin is a good indicator of overall company profitability because it shows what percentage of each dollar of revenue the company ends up keeping as profit.
What can I learn from a profit margins metric?
Tracking profit margins with metrics helps you to see what is a good net profit margin. It allows you to see changes so you can investigate what caused those changes, and avoid them in the future if they are bad or replicate them if there are good.
A good way to view your margins data is as an area chart like the one above. The blue represents Gross Profit Margin. The green represents Net Profit Margin. Say your company had a goal to maintain a Net Profit Margin of 14%. The dashed line would represent that goal. The Key value at the top shows what your Net Profit Margin was for your last full month of business compared to the prior month’s Net Profit Margin.
If the chart above represented data from your company, you would see that between March and October in 2015 when your Gross Profit Margin dipped and then increased, so did your Net Profit Margin.
But after October, as your Gross Profit Margin began to decrease again, your Net Profit Margin remained fairly steady around your 14% goal line. This could be a sign that you were able to cut some of your operating costs to balance out the lost revenue from decreasing gross profits.
If Gross Profit Margins are decreasing, you need to figure out what is causing the decrease. Maybe a supplier has raised the rates of the raw materials you purchase?
An increase in your Gross Profit Margin can indicate growing economies of scale as costs decline per unit as raw materials decrease due to larger purchase quantities.
If your Net Profit Margin is shrinking but your Gross Profit Margin remains unchanged, your operating expenses could be increasing.
For a new business, a low profit margin can be the result of not hitting your full production or service capacity. Understanding if you have a revenue or a cost problem is key in properly interpreting your Net Profit Margin.
How to calculate Gross Profit Margin
To accurately calculate your Gross Profit Margin, you need to understand the difference between variable and fixed costs. Variable costs change based on the amount of product produced; they are a direct result of product creation and are known as your COGS. Fixed costs are typically less subject to changes in production volume and are considered operating expenses.
Below is a list of variable costs and a list of fixed costs created by Entrepreneur.com to help you when calculating your Gross Profit Margin and Net Profit Margin.
Some of the costs below fall in a gray area and could be considered mixed or fixed costs. Because of this, the list isn’t the ultimate catch-all method of separating your costs. Ultimately, you will have to decide where you will place certain expenses in your margins calculations.
Variable costs can include:
- Materials used
- Direct labor
- Plant supervisor salaries
- Utilities for a plant or warehouse
- Depreciation expenses on production equipment and machinery
Fixed costs can include:
- Office expenses like supplies, utilities and a telephone for the office
- Salaries and wages of office staff, salespeople and officers and owners
- Payroll taxes and employee benefits
- Advertising, promotional and other sales expenses
- Auto expenses for salespeople
- Professional fees
To calculate Gross Profit Margin, you need to first figure out what your gross profit is, a monetary amount. Gross profit is revenue minus cost of goods sold (COGS). Gross Profit Margin is gross profit divided by revenue, a percentage.
You might be wondering why it’s necessary to change a dollar amount to a percentage. Investopedia points out that using percentages to talk about profitability allows for better historical comparisons of your own company, which allows you to track profitability trends more easily.
Here are gross profit equations, for Gross Profit and Gross Profit Margin respectively:
Gross Profit = (Revenue – Cost of Goods Sold (COGS))
Gross Profit Margin = Gross Profit / Revenue
TIP: When calculating your Gross Profit Margin, it can be helpful to calculate it for each specific product you offer so you have a clearer picture of what each specific product costs your company to produce and how much profit it adds to the company.
How to calculate Net Profit Margin
To calculate Net Profit Margin, you need to figure out what your net profit is. Net profit is gross profit minus operating expenses and all other expenses, such as taxes and interest paid on debt. Your Net Profit Margin is net profit divided by revenue.
Here are equations for net profit and Net Profit Margin:
Net Profit = (Revenue – Cost of Goods Sold – Operating Expenses – Other Expenses – Interest – Taxes) / Revenue
Net Profit Margin = Net Profit / Revenue
What if you have a negative net profit?
Having a negative net profit is basically the same as having a negative Free Cash Flow. It is common for young growing companies to have a negative net profit. For larger, more established companies, a negative net profit is not good and is a sign that changes need to be made.
How do I create profit margins metrics?
The metric above was created with Grow. If you use Quickbooks, Zoho Books, or other accounting software to keep your finances up-to-date, Grow can pull data from those platforms to create a metric like the one above.
To see if Grow integrates with your financial platform, view our integrations here.