Gross margin is the difference between revenues and the cost of goods sold, which leaves a residual margin that is used to pay for selling and administrative expenses.
Gross Margin is a company’s total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations.
Net Margin is the ratio of net profits to revenues for a company or business segment – typically expressed as a percentage – that shows how much of each dollar earned by the company is translated into profits. Net margins can generally be calculated as:
Net margin is the residual earnings left after all expenses have been deducted from revenues. This means that the following key differences exist between the gross margin and net margin:
- Income statement location. The gross margin is located mid-way down the income statement, immediately after the cost of goods sold line item. Net margin is located at the bottom of the income statement, following all expense line items.
- Size. The gross margin is always larger than the net margin, since the gross margin does not include any selling and administrative expenses.
- Tax effect. The gross margin is not net of any income tax expense, while the net margin does include the effects of income taxes.
- Type of cost inclusions. The gross margin is more likely to incorporate a high proportion of variable expenses, including the direct materials required to generate sales. The net margin contains a much lower proportion of variable expenses, since it also includes selling and administrative expenses, many of which are fixed costs.
The gross margin and net margin are both considered critical to the financial health of a business, so both are closely watched on a trend line. Any drop in either measurement will likely trigger a detailed investigation by management.