Gross profit margin vs net profit margin

 

 

If you’re in business, Gross Profit and Net Profit probably aren’t new terms. In fact, you’ve most likely seen them on your Profit and Loss statement many times.

However, some of the most common questions we are asked as business advisors relate to gross profit and net profit margins. In particular, what it is, how to calculate it, and what insights it can bring.

To help you navigate this, we asked our business advisors Shaun and John to explain.

 

What is gross profit margin?

Gross profit is your profit or revenue minus your cost of goods sold (COGS). You’ll find this towards the top of your Profit and Loss sheet, underneath your trading income and cost of sales

Your gross profit margin is simply the percentage of this, showing you what percentage of your income is gross profit. To calculate your profit margin, divide your gross profit by your revenue and times this by one hundred.

 

(Gross Profit / Revenue) x 100 = Gross Profit (GP) margin

Applying this to a live example, if you made $1,000,000 in income and your cost of goods sold (COGS) was $700,000, your gross profit would be $300,000. Your gross profit margin would then be:

(300,000 / 1,000,000) x 100 = 30%

 

What is net profit margin?

Similarly to your gross profit margin, your net profit margin is the percentage of net profit. Your net profit can be found under your operating expenses on your Profit and Loss sheet, and is your profit after you deduct your COGS, operating expenses as well as any interest and depreciation.

Your net profit (sometimes referred to as net income) is your actual profit after you minus all expenses and costs, with your net profit margin simply the percentage of net profit.

 

(Net Profit / Revenue) x 100 = Net Profit margin

Using the same example as before with an income of $1 million dollars and a net profit of $200,000, then your net profit margin would be 20%.

(200,000 / 1,000,000) x 100 = 20%

 

What can you learn from gross profit and net profit margins?

Understanding your gross profit margin and net profit margin can help you assess the health and profitability of your business. As well as understanding your profits, they can help you measure business efficiency, identify income risks and income improvements. 

In project-focused industries such as building and construction, it can also help you analyse the profitability, efficiencies and risks of your projects.

Here at Mead Partners, our business advisory team also analyses both gross profit margin and net profit margins to provide insight into pricing structures, income strategies, and proactive risk management.

 

What your gross profit margin helps you measure

Your gross profit gives you a great snapshot of your overall profitability and business health

It can help you assess: 

• Profitability by income stream, project, product/service, or even teams
• Product and service pricing structures or margins
• Underperforming products and services
• Income risks and where you might need to reduce costs
• How efficient you are at converting raw materials, labour or services into profit

 

What net profit margin can tell you

While net profit margin also measures your profitability and is used to assess your business health, it plays an important part in understanding the effectiveness of your operations.

By tracking your net profit margin, you can:

• Uncover operational inefficiencies
• Assess if you’re generating enough sales to cover costs
• Forecast potential net profit dips (or increases)
• Better understand operational costs and potential risks
• Identify ways to reduce production costs

Your net profit margin can also help you determine your company’s overall value and if you have enough profit to reinvest in your business, expanding operations, investing in equipment, or increasing marketing efforts.

 

3 ways you can improve your gross profit and net profit margins

Increase your product and service pricing

By increasing your product and service pricing, you automatically increase your revenue. This, in turn, improves both your gross profit and net profit margins.

It’s important to increase pricing overtime and consider competitor pricing, your service or product positioning and overall perceived value, and also the market’s demand. Even a 1% pricing increase over time can make a big difference over the long term.

For those in project-based industries such as building and construction, this applies to project margins.

Working with your business advisor, you can assess profit margins on each product or service and make strategic adjustments overtime.

> What gross profit margin should builders be charging?

 

Reduce operating or goods and services costs

While reducing costs seems simple, there are good and bad ways to go about this. 

For example, seeking out materials that are cheaper can help reduce costs. However if the material is cheaper quality, this could impact your delivery quality. The cheaper option might also have different impacts, such as importing cheaper building materials may require longer delivery timelines.

Analysing your operational costs can uncover expenses that can be removed or reduced by consolidating services, negotiating better pricing, or implementing strategies that drive operational efficiencies.

Where we often see people go wrong is cutting operating costs too far, making the operation too lean (impacting efficiencies and productivity) or not having enough to invest in your business over the long term. Working with your business advisor, you better understand your breakeven point and make strategic cost cutting decisions towards your goals.

 

Remove underperforming products and services

You may love a service you’re providing, but are your customers? It might also be too expensive to produce or deliver. Perhaps there is part of your offering you could contract out instead of having a dedicated team and all the expensive equipment to go with it. By reviewing your products and services profitability, you can assess which are not profitable, in demand, or are not cost effective.

As a business owner – who has created all these services or products – it can be hard to be objective during this process. Working with your business advisor, you can review services and products objectively and cut those not doing you any profitability favours. 

 

Where to start

Analysing numbers and profitability can sometimes be stressful, especially when you’re juggling the day to day of your business as well. Meeting with your accountant once a year can also be too late to make strategic changes.

That’s why we have monthly or quarterly check-ins with our business advisory clients, providing guidance, proactive advice and actions you can implement bit by bit.