For a business to be successful, it must generate and maintain profitability in order for it to grow. The two most useful measures of profitability are the gross and net profit margin, both of which are shown in the financial projections template.
In broad terms, the gross margin is a measure of the profitability of the products the business produces and sells, whereas the net margin is a measure of the overall profitability of the entire business itself.
Gross Profit Margin
Gross profit margin or simply gross profit or gross margin, refers to the amount left over after deducting the cost of sales from the revenue.
And the gross margin percentage is the gross margin expressed as a percentage of revenue.
The gross margin and gross margin % indicate whether or not the selling price of the product or service is sufficient to cover the direct costs of producing the product.
For example, if the selling price of a product is 20.00 and the direct costs, such as materials, labor and possibly some overheads are 8.00, then the gross margin and gross margin % are calculated as follows:
Gross margin = Revenue - Cost of sales Gross margin = 20.00 - 8.00 = 12.00 Gross margin % = Gross margin / Revenue Gross margin % = 12.00 / 20.00 = 60%
In this example the business makes 12.00 gross margin per unit sold, which is 60% of the selling price.
The gross margin does not take into account any other operating expenses such as rent, administration costs, and finance costs. A positive gross margin means that the business is capable of producing a product and selling it at a price sufficient to cover its direct production costs.
The gross margin of a business depends on the industry in which it operates and is very important in the calculation of the break-even point for the business.
A more detailed explanation is given in our article on how to calculate the gross margin percentage.
Net Profit Margin
Net profit margin is usually referred to as net income, and is shown on the financial projections template as the final line on the income statement.
And the net margin percentage is the net margin expressed as a percentage of revenue.
The net margin is the amount remaining after deducting all the expenses of the business from the gross margin, and as such represents the ability of a business to generate profit (or loss) from its revenue.
The level of net profit and net profit margin % is an indication of how well a business can control its expenses in relation to its revenue. A more detailed explanation of the use of net margin is given in our article on profit margin ratios.
As the net profit takes into account all the expenses including finance costs (capital structure), and income tax expense (tax system) of the business, it measures the profitability of the entire business and not (as the gross margin does) just the profitability of the products produced by the business.
Gross and Net Profit Margin Example
As an example of the use of gross and net profit margins, suppose the income statement of a business is as shown below.
|Cost of sales||45,000|
|Income before tax||10,000|
|Income tax expense||3,000|
In this example, the gross and net profit margins are highlighted in blue and green respectively.
The gross and net profit margin can be calculated as follows:
Gross margin = Revenue - Cost of sales Gross margin = 100,000 - 45,000 = 55,000 Gross margin % = Gross margin / Revenue Gross margin % = 55,000 / 100,000 = 55% Net margin = Gross margin - Expenses Net margin = 55,000 - 48,000* = 7000 Net margin % = Net margin / Revenue Net margin % = 7,000 / 100,000 = 7%
* Note that the expenses include operating expenses (30,000), depreciation (10,000), finance costs (5,000), and income tax (3,000), and total 48,000 as shown above.
Use of Gross and Net Margins
It is useful to consider both the gross and net profit margins of a business when producing financial projections for a business plan.
The gross margin indicates whether the business is managing to produce and sell products profitably, whereas the net margin takes into account all expenses, and shows whether the entire business is capable of making a profit.
Comparisons should be made of the gross and net profit margins to businesses in the same industry to check whether the financial projections show realistic and competitive values.
In the financial projections template, the gross margin percentage is entered as an input variable, allowing both the gross and net margins to be calculated and shown on the income statement of the template.
The net margin percentage is also calculated and shown on the ratios page of the financial projections template, under the heading of profitability.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.