The difference between gross margin and net margin

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What is Gross Margin?

Gross margin is the difference between revenues and the cost of goods sold, which leaves a residual margin that is used to pay for selling and administrative expenses. It is typically included as a subtotal on a company’s income statement. Gross margin is closely watched by analysts, who want to know if an organization is under any pricing pressure from competitors or is paying more for its raw materials - both of which would cause its gross margin to decline.

What is Net Margin?

Net margin is the residual earnings left after all expenses have been deducted from revenues. It is usually stated as a separate line item near the bottom of an income statement. This is the ultimate measure of whether a business is capable of generating a return on its sales, after all operating and non-operating income and expense items have been taken into account.

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Comparing Gross Margin and Net Margin

The following are key differences between the gross margin and net margin of a business:

  • Income statement location. The gross margin is located mid-way down the income statement, immediately after the cost of goods sold line item. Net margin is located at the bottom of the income statement, following all expense line items.

  • Size. The gross margin is always larger than the net margin, since the gross margin does not include any selling and administrative expenses.

  • Tax effect. The gross margin is not net of any income tax expense, while the net margin does include the effects of income taxes.

  • Type of cost inclusions. The gross margin is more likely to incorporate a high proportion of variable expenses, including the direct materials required to generate sales. The net margin contains a much lower proportion of variable expenses, since it also includes selling and administrative expenses, many of which are fixed costs.

The gross margin and net margin are both considered critical to the financial health of a business, so both are closely watched on a trend line. Any drop in either measurement will likely trigger a detailed investigation by management.