More specifically, profit margin and gross profit margin are ratios used to determine a business’ financial health and performance. Both are expressed as percentages, but the net profit margin measures a company’s bottom line, while the gross profit margin focuses on the efficiency of production costs.
Let’s take a look at the distinct differences between the two.
Gross Profit Margin
It is how much money your business makes once you deduct the cost of goods produced or expenses associated with providing its services from the total revenue. On the other hand, the gross profit margin is the percentage of your revenue exceeds the cost of sales. A gross profit margin is a reliable tool when comparing performance over time.
Businesses, regardless of size, use this to measure the efficiency of labour and supplies used to provide the products and services you offer your clients. This includes raw materials, labor costs, commissions for sales staff, merchant service fees for credit card purchases, equipment, utilities, and shipping. These are all variable costs that fluctuate depending on the level of output.
Gross profit margin does not include fixed costs like rent, advertising, insurance, or salaries of employees not directly involved in the production.
Net Profit Margin
As mentioned above, the net profit margin is the bottom line of the company. In other words, it is the percentage of net income generated from your business’s revenue. It is also considered the ultimate measure of your business’s profitability.
While gross margin focuses on expenses from raw materials and labor costs, the net profit margin takes into account the total cash flow of your business. Aside from the cost of sales, this includes operational costs, other expenses, income generated outside business sales, and taxes.
The net profit margin shows whether an increase in revenue translates to increased profitability.
When to use Gross Profit Margin and Net Profit Margin?
For small businesses and startups, gross margin is useful in determining how well new products are doing and whether or not you are utilizing your resources efficiently. Higher gross margins are good indicators that should there be a slight increase in the cost of goods production, and your business won’t go bankrupt.
You can also compare whether the increase in output levels generates more income and how competitive your production is compared to similar industry businesses.
For an in-depth analysis of your business’s overall profitability, however, net profit margin provides the most accurate measurement.
Analysts and investors typically use both gross profit margin and net profit margin to gauge a business’s potential in translating sales into income. A good margin is favourable for your company when it comes to applying for loans and trying to get more investors on board.
It is also wise to use both gross margin and profit margin for comparison with competitors in the industry to make sure your business remains strong and competitive in the market. Both ratios can also be used to determine trends in profit generation over periods of time.
Additional Related Content – How Do You Calculate for Profit Margin?
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