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. If a company makes more money per sale, it has a higher profit margin.
Gross Profit Margin
Gross profit margin is a measure of profitability where it shows the percentage of revenue that exceeds the cost of goods sold. It illustrates how successful a company's executive management team is in generating revenue from the costs that are involved in producing their products and services. In short, the higher the number, the more efficient management is in generating profit for every dollar of labor cost involved.
The gross profit margin is calculated by taking total revenue minus the cost of goods sold (COGS) and dividing the difference by total revenue. The gross margin result is typically multiplied by 100 to show the figure as a percentage. The COGS is the amount it costs a company to produce the goods or services that it sells.
Explaining Gross Vs. Net Profit Margin
Example of Gross Profit Margin
For the fiscal year ending September 30, 2017, Apple Inc. (AAPL), reported total sales or revenue of $229 billion and COGS of $141 billion as shown from their consolidated 10K statement below.
Apple's gross profit margin for 2017 was:
($229 - $141) ÷ $229 = .38 X 100 = 38%
This means that for every dollar Apple generates in sales, the company generated 38 cents in gross profit before other business expenses were paid. A higher ratio is usually preferred as this would indicate that the company is selling inventory for a higher profit. Gross profit margin provides a general indication of a company's profitability, but it's not a precise measurement.
Gross Margin Versus Gross Profit
It's important to note the difference between the terms gross profit margin and gross profit. Gross profit margin is shown as a percentage, while gross profit is an absolute dollar amount.
The gross profit is the absolute dollar amount of revenue the a company generates beyond its direct production costs. Thus, an alternate rendering of the gross margin equation becomes gross profit divided by total revenues. In shown on the statement above, Apple's gross profit figure was $88 billion (or $229B - $141B).
In short, gross profit is the total number of gross profit after subtracting revenue from COGS or $88B in the case of Apple, but the gross margin is the percent of profit Apple generated per the cost of producing their goods or 38%.
The gross profit figure is of little analytical use because it presents a number in isolation, rather than rendering a figure calculated in relation to both costs and revenue. Therefore, the gross profit margin (or gross margin) is more significant for market analysts and investors.
To illustrate the difference, consider a company showing a gross profit of $1 million. At first glance, the profit figure may appear impressive, but if the gross margin for the company is only 1%, then a mere 2% increase in production costs is sufficient enough to make the company lose money.
Gross profit and gross margin are only two measurements of profitability. As we'll explore next, net profit margin, which includes a company's total expenses, is a far more definitive profitability metric, and the one most closely scrutinized by analysts and investors.
Net Profit Margin
The net profit margin is the ratio of net profits to revenues for a company or business segment. Expressed as a percentage, net profit margins show how much of each dollar collected by a company as revenue translates into profit.
Net profitability is an important distinction since increases in revenue do not necessarily translate into 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. Although it may appear more complicated, net profit is calculated for us and shows up on the income statement as net income.
Example of Net Profit Margin
Apple reported a net income number of roughly $48 billion (highlighted in blue) for the fiscal year ended September 30, 2017, as shown from their consolidated 10K statement below. And we saw earlier, Apple's total sales or revenue was $229 billion for the same period.
Apple's net profit margin for 2017 was:
$48 billion ÷ $229 billion = .21 X 100 = 21%
A 21% net profit margin indicates that for every dollar generated by Apple in sales, the company kept $0.21 as profit. A higher profit margin is always desirable since it means the company generates more profits from the company's sales.
However, profit margins can vary by industry. Growth companies might have a higher profit margin than retail companies, but retailers make up for their lower profit margins with higher sales volumes.
It's important to note that it's possible for a company to have a negative net profit margin. A negative net profit margin occurs when a company has a loss for the quarter or year, but the loss could be a temporary issue for the company. Reasons for losses could be increases in the cost of labor and raw materials, recessionary periods, and the introduction of disruptive technological tools that could affect the company's bottom line.
Investors and analysts typically use both gross profit margin and net profit margin to gauge how efficiently a company's management is in earning profits relative to the costs involved in producing their goods and services. It's best to compare the margins to companies within the same industry and over multiple periods to get a sense of any trends.