Margin Metrics: Gross v Net Margins

This is part 2 of our series on Margin Metrics, previous segments are available in our archives.

What’s your margin?

In business, you often hear about companies being measured by their “margins”. But what do we mean by “margins” and how can you use them to make decisions?

Your margin refers to the difference between your revenue and costs, specifically what percentage of your total revenue is left after removing costs.

margins

That is, of course, extremely vague which is why margins come in three different flavors: Gross margins, Net margins and Contribution margins. We’ll cover the first two today and leave Contribution margins for tomorrow.

Your Gross Margin is calculated by subtracting your total cost of goods sold (COGS) from your total revenue and then dividing by total revenue. The cost of goods sold only includes the cost of providing or manufacturing the product or service and does not include all of your personnel (salaries), marketing costs, etc. For example, if you make basketballs and sold $10,000 worth of balls while you spent $5,000 making those balls then your Gross margin would be 50%.

gross_margin

Your Net Margin is calculated similarly to Gross Margin but instead of subtracting just COGS, you subtract all variable costs which include your COGS, marketing, sales, etc. Going back to our basketball example, if you sold $10,000 worth of balls, spent $5,000 making those balls and another $2,500 on salaries, office space and advertising (for a total of $7,500 in costs) then your Net margin is 25%.

net_margin

Many people consider Net Margin the most accurate measurement of margin and hence the best measure of profitability. However, it can be hard to measure so in the early days many companies will start with Gross Margin and move to Net Margin as they grow.

Great, so what?

Now that you have your gross and net margins in hand, there are a lot of valuable strategic questions you can answer:

  • Is my business getting more or less efficient as we grow? By tracking your net margins over time, you can tell if your business is gaining or losing profitability as you grow. If your net margins were 40% when you had $100k in revenue but are 20% when you have $500k in revenue then you are becoming less profitable as your revenue grows.
  • How do I compare to the competition? Margins give you a way to compare two businesses that have wildly different amounts of revenue and products. If your business generates $500k in revenue but has 30% margins and your competition has $2M in revenue with 20% margins then you know that your business is more efficient even though their business is larger.  

Tomorrow we’ll jump into another form of margins, Contribution Margins, which can answer even more strategic questions.

 

Quote of the day: “Fast is fine, but accuracy is final.” – Wyatt Earp