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Difference Between Gross Profit Margin and Net Profit Margin

10 Mins 29 May 2023 0 COMMENT

As an investor, it is imperative to invest in companies that are profitable in order to earn capital gains and dividends. A company’s profitability can be assessed by investors using profitability ratios such as the gross profit margin and the net profit margin. This article explains the difference between the two and the importance of understanding them in order to make informed investment decisions.

What is gross profit margin? 

Gross profit margin is a profitability measure that signifies the gross profit a company earns against every single rupee of its total revenue. Also known as the gross margin it shows the percentage of total revenue that a company earns as gross profit.

The gross profit margin reflects the efficiency of a company in generating revenue taking into consideration the production costs. Hence, a higher gross profit margin number means that the company is generating more profit for every rupee of cost incurred.

For example, if the gross profit margin of a company is 65%, it is earning Rs 0.65 gross profit against Re 1 of its total revenue.

What is net profit margin?

Net profit margin, also known as the net margin, is the percentage of the total revenue that a company reports as net profit. The net profit is the total profit of the company after deducting its indirect cost i.e., interests, taxes, and operating costs from its gross profit.

It is to be noted that the gross profit is calculated after deducting the cost of goods sold (COGS) from total revenue. Meanwhile, while calculating net profit, all expenses and taxes are deducted from the total revenue. This will make the gross profit margin of a company always higher than its net profit margin.

How are gross profit margin and net profit margin calculated?

One of the key difference between gross margin and net margin is its formula of calculation. Read on to learn how gross and net profit margins can be calculated.

To calculate gross profit margin, you must first calculate gross profit. You can calculate the gross profit by deducting the following expenses the total revenue:

  • Raw materials cost
  • Labour cost
  • Production cost
  • Cost incurred for inventory maintenance

Once you have calculated the gross profit, use the following formula to calculate gross profit margin:

Gross profit margin = (Gross profit / Total revenue) x 100

Calculating net profit margin becomes very easy on knowing gross profit. Similar to gross profit margin you must first calculate net profit. You can calculate the net profit by deducting the following items from the gross profit.

  • Cost of revenue
  • Depreciation cost
  • Administration overheads
  • Interest payments on debts
  • Taxes

On obtaining the net profit, use the following formula to calculate the net profit margin:

Net profit margin = (Net profit/ Total revenue) x 100

Here’s an example to understand the gross and net profit margin calculations better:

Below mentioned is the income statement of ‘Company A’ for the financial year 2021-22.

Particulars

Amount (in Rs)

Total sales

10,00,000

Cost of goods sold

2,00,000

Wages

40,000

Gross profit

7,60,000

Interests

30,000

Taxes

70,000

Operating costs

3,00,000

Miscellaneous expenses

1,00,000

Net profit

2,60,000

Substitute the values respectively in the gross profit and net profit margin formula:

  • Gross profit margin = (Gross profit / Total revenue) x 100

        Gross profit margin = (7,60,000/ 10,00,000) x 100 = 76%

  • Net profit margin = (Net profit/ Total revenue) x 100

      Net profit margin = (2,60,000 / 10,00,000) x 100 = 26%

How to interpret gross profit margin and net profit margin?

Both gross profit margin and net profit margins are widely used profitability ratios. They help you understand the company’s profitability and cost management efficiency. This in turn helps you grasp details about the company’s financial health. Knowing this information, you are able to make suitable investment decisions. Investors can make use of both margins to compare the financial health and operational efficiencies of different companies.

What is the difference between gross profit margin and net profit margin?

Refer to the following difference table to get a clear view of the Gross margin vs Net margin comparison:

Point of difference

Gross profit margin

Net profit margin

Meaning

Gross margin is the total percentage of gross profit generated from total revenue.

Net margin is the total percentage of net profit generated from total revenue.

Types of costs included

Gross profit margin includes all direct costs. They are costs incurred during the production of goods and services.

Net profit margin includes all indirect costs. These costs are typically incurred for selling goods and services.

Inclusion of tax

Gross profit margin calculation does not include taxation expenses.

Net profit margin calculation includes taxation.

Size

Gross profit margin is always higher than net profit margin as it does not include indirect costs (primarily administration and selling costs.)

Net profit margin is always lower than gross profit margin as it considers indirect cost incurred by the company.

 

Bottom line

Gross profit margin and net profit margin are the most popular profitability ratios. Both ratios reveal great details about the company’s financial health primarily its cost management efficiency and profitability. Employ these profitability ratios to find the right stock company and make a suitable investment.

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