Gross profit margin and net profit margin are two separate profitability ratios used to assess a company's financial stability and overall health.
Profit margin is a percentage measurement of profit that expresses the amount a company earns per dollar of sales. Obviously, if a company makes more money per sale, it has a higher profit margin.
The gross profit margin shows total revenue minus the cost of goods (the amount it cost the company to produce the goods or services that it sold, commonly referred to as cost of goods sold, or COGS). The calculation to arrive at gross profit margin is:
Gross profit margin = (revenue - cost of goods) / revenue
As a simple example, if a company sells goods for $100, and the cost to the company to produce the goods is $70, the company's gross profit margin is 30%. Gross profit margin provides a general indication of a company's profitability, but it is not a precise indication.
The net profit margin is a more accurate measure of a company's profitability, as it reveals the percentage of revenue that actually reflects a company's profit per dollar of sales. Net profitability is an important distinction, since increases in revenue do not necessarily translate into actual increased profitability. Net profit is the gross profit (revenue minus cost of goods) minus operating expenses and all other expenses, such as taxes and interest paid on debt. The formula for net profit margin is as follows:
Net profit margin = (revenue - cost of goods - operating expenses - other expenses - interest - taxes) / revenue
Examining its net profit margin can help a company gain a much clearer picture of its overall expenses compared to revenue. It is often much easier for a company to increase its profitability by reducing costs than by increased sales, especially if the company operates in a very competitive market.
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