Gross, operating, and net profit margins all reveal different aspects of a company’s performance, such as what the business earns in revenue and where business expenses go. The gross profit margin calculates how much a company spends on producing goods or providing services only. Operating profit margin, however, considers the cost of goods sold as well as the operating costs of a business. Finally, the net profit margin calculates the profits a company retains after paying for the company’s operating and tax expenses.
In order to determine a company’s financial health, analysts and business executives review financial statements that include three important metrics: gross, operating, and net profit margins. Each of these margins reveals the profit a company collects from their total revenue after paying for certain expenses. As such, all three are necessary to fully understand a company’s profits.
Keep reading to learn how each margin is used in business calculations, how each one differs from the other, and why every margin is essential for successful companies.
What is a gross profit margin?
The gross profit margin shows a company’s efficiency in producing its products or sales. A higher gross profit margin number indicates a company takes in more total gross profit per dollar of revenue. To determine this, the company considers the direct costs involved in producing goods or providing services.
These direct costs vary among companies depending on the kind of business or industry. For instance, companies involved in the production and manufacturing of goods use the cost of goods sold. However, service-based companies only calculate the cost of providing their services.
What is a good gross profit margin ratio?
For most companies, a good gross profit margin ratio is between 50% and 70%. This is true for businesses like retailers, restaurants, and manufacturers.
However, for other types of businesses, a gross profit margin of 50% might be too low, such as for banks, legal firms, or other service industry companies. Service industry companies typically report gross profit margins in the high 90% range because of substantially lower production costs than manufacturers.
What is the difference between gross profit and gross margin?
Both gross profit and gross margin show a company’s profitability ratio when comparing revenue to production costs. However, gross profit and gross margin show these ratios in different ways.
Gross profit shows a company’s top-line earnings as a whole-dollar amount. These are revenues associated with producing and selling a company’s products.
The gross margin shows a company’s revenue that exceeds its costs of goods sold (COGS) through a percentage. It demonstrates the revenue a company generates from the costs involved in producing its products and services. The higher the margin, the more effective the company’s management is in generating revenue for each dollar of cost.
What is an operating profit margin?
The operating profit margin (OPM) examines a company’s ability to manage its indirect costs and how indirect costs affect the bottom line. Indirect costs include research and development, marketing expenses, general and administrative costs, depreciation, and amortization.
For example, a 15% operating profit margin is a $0.15 operating profit for every $1 of revenue earned.
This section of the income statement shows how the business is investing in areas that it hopes to improve, such as marketing and capital investment allocations. If a company has a high gross profit margin and a low operating profit margin, the company’s indirect expenses might be too high.
What is a company’s net profit margin?
The net profit margin (NPM) is, put simply, revenue minus expenses. This margin takes all expenses into account, including interest and taxes.
Net profit demonstrates a company’s ability to manage its interest and tax payments. There are several kinds of interest payments, including the interest a company pays stakeholders on capital instrument debt and interest earned from short-term and long-term investments.
The net profit margin shows how much of each dollar a company collects as revenue goes into profit. This is otherwise known as net profitability.
However, not all revenue increases mean increased profitability for a company.
What is a good net profit margin?
A higher net profit margin is always desirable. Let’s say a company has a 31% net profit margin. This means the company keeps $0.31 as profit for each dollar earned in revenue.
It’s possible to have a negative net profit margin, too. A negative net profit margin occurs when a company has a loss for a quarter or year. Though the loss could be a temporary issue, typical losses could include increases in the cost of labor, raw materials, and recessionary periods. Another is the introduction of disruptive technological tools, which might affect the company’s bottom line (operating profit margins).
Is net profit margin the same as operating margin?
Both net profit and operating margins are important tools used in a company’s income statement. However, these two ratios differ in context.
- Net profit margins calculate the actual margin earned after interest payments (debt and tax outflows).
- Operating margins refer to the company’s profits earned from its core operations. This can be a more useful and reliable measurement as operating margins tell a company exactly how profitable it is in its core operations.
For instance, in any technology company, the operating margin would solely include its profits generated from the technology business itself. The revenues generated by the technology company and the related costs of the business alone are considered, too. To get net profit margins, the business would consider its non-operating costs like interest charges and taxes.
Since operating margins exclude the impact of extraordinary expenses and incomes, they are more reliable as a business assessment.
Why are these margins important to business owners?
While each margin sounds relatively similar, they all elaborate on a company’s profits and expenses to provide a clearer picture.
For instance, let’s say a company has a gross profit margin of 83%. Executives may see this and believe they’re making enough money to expand production. But without looking at the company’s operating and net profit margins, these executives aren’t getting the full picture of their company’s financial health.
What is an overall good profit margin?
A good profit margin varies considerably from one industry to the next and depends upon the size of the company.
However, a general rule of thumb remains. A 5% net profit margin is considered low, a 10% margin is average, and a 20% margin is high or “good.”
- There are three major margins included in a company’s financial statement: gross, operating, and net profit margins.
- The gross profit margin considers only the costs associated with producing goods or services (the cost of goods sold).
- Operating profit margin is the revenue minus COGS and operating expenses. This provides a clearer picture of a company’s financial health.
- A company’s net profit margin calculates a company’s profitability after business and additional expenses (interest and taxes for example) are paid.
View Article Sources
- Manage your finances — U.S. Small Business Administration
- Financial Information — Library of Congress
- Financial Statement Data Sets — U.S. Securities and Exchange Commission
- Gross Profit vs. Net Income — SuperMoney
- What is Gross Monthly Income? (and 4 Ways to Calculate It) — SuperMoney
- What is Annual Income? — SuperMoney
- How to Calculate Your Adjusted Gross Income — SuperMoney
- What Is Interest Income? — SuperMoney
- Business Loan Refinancing: The Definitive Guide — SuperMoney