The Difference Between Gross Margin and Net Margin
Gross margin and net margin are both essential profitability indicators. It’s important, however, to know the difference between these two ratios that present two very different portraits of your business’s operating efficiency.
Gross margin and the gross margin rate
The gross margin is the indicator that determines the difference between direct production costs and the selling price. Consider the example of a carpenter who makes and sells chairs. The carpenter has determined that the chairs’ manufacturing cost is allocated as follows:
- Raw materials: wood – $50
- Assembly: labour – 2 hours at $30/hour – $60
- Transportation: $10
Based on this information, the total manufacturing cost is $120 per chair. The carpenter has determined a selling price of $150 per chair. This means the carpenter has a $30 surplus over direct costs. The gross margin per unit on the sale of the chairs is therefore $30.
Gross margin can also be presented as a percentage using the gross margin rate, which is calculated as follows:
(Gross margin/sales) X 100 = gross margin rate
In the carpenter’s case, the gross margin and selling price are $30 and $150 respectively, which gives a gross margin rate of 20%.
The net margin is a performance indicator that measures a business’s overall profitability. The net margin is calculated using the gross margin less administrative expenses (marketing, promotion, accounting, legal fees, etc.) and fixed costs. These expenses differ from the costs included in the gross cost calculation in that they are not directly related to the production and/or delivery of goods and/or services.
Let’s go back to the carpenter. Let’s say he sold 100 chairs during the year at $150 per chair, with a unit cost of $120. The carpenter also has the following administrative/fixed costs during the year:
- Rent: $100/month – $1,200
- Heat and electricity: $30/month – $360
- Accounting fees: $740
Using this information, first, the gross margin is calculated:
Total sales: 100 chairs X $150/unit = $15,000 (-) direct costs: 100 chairs X $120/unit = $12,000 = gross margin: $15,000 – $12,000 = $3,000
To calculate the net margin, administrative and fixed expenses of $2,300 are deducted.
Gross margin: $3,000 – administrative and fixed expenses: $2,300 = net margin: $700
As is the case with the gross margin, the carpenter’s net margin rate can also be calculated.
Net margin/sales x 100 = net margin rate
$700/$15,000 X 100 = 4.67%
This means that the carpenter’s gross margin rate is 4.67%, i.e. for each $100 of sales, the business has a net profit of $4.67.
To summarize, net margin and gross margin are two key financial performance indicators for any business. It’s important that the accounting system be in order to avoid distorting these ratios.
Entrusting your accounting to Operio’s professionals means you have the assurance that your financial statements properly reflect your business’s operations and that you are being supported in your growth.
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