Gross and net profit margin: what each pound of sales leaves behind
Gross profit margin: gross profit written as a percentage of revenue, showing how much of each pound of sales survives the direct cost of the product.
Net profit margin: net profit written as a percentage of revenue, showing how much of each pound of sales survives every cost the business pays.
- The last guide left a shop with revenue of £250,000, gross profit of £100,000 and net profit of £30,000, and both margins are built from those three figures.
- Gross profit margin is found from gross profit margin=gross profitrevenue×100\text{gross profit margin} = \dfrac{\text{gross profit}}{\text{revenue}} \times 100gross profit margin=revenuegross profit×100.
- Substituting the shop's figures gives £100,000£250,000×100=40%\dfrac{\pounds 100{,}000}{\pounds 250{,}000} \times 100 = 40\%£250,000£100,000×100=40%.
- So 40p of every £1 of sales is left after the direct cost of the product, and that 40p is all the shop has to cover rent, wages, marketing and every other running cost.
- Net profit margin is found from net profit margin=net profitrevenue×100\text{net profit margin} = \dfrac{\text{net profit}}{\text{revenue}} \times 100net profit margin=revenuenet profit×100.
- Substituting the same revenue gives £30,000£250,000×100=12%\dfrac{\pounds 30{,}000}{\pounds 250{,}000} \times 100 = 12\%£250,000£30,000×100=12%.
- So 12p of every £1 of sales is left once every cost is paid, and that 12p is what the owner can take out of the business or reinvest in it.
Why a margin tells you more than the profit figure alone
- A margin strips out the size of the business, because £30,000 of profit would be a strong year for a market stall and an alarming one for a supermarket chain.
- That makes two comparisons possible: the same margin measured for a rival of a completely different size, and the same margin measured for this business last year.
- Revenue can rise while the margin falls, which tells the owner the shop is selling more but keeping less out of each sale, a warning the profit figure on its own hides.
- Greggs sells cheap hot food in very high volume, so a thin margin on each sausage roll is normal and the profit comes from the number of sales.
- Dyson sells on design and engineering at a premium price, so it works with a far wider margin on each machine and sells fewer of them.
- Setting Greggs's margin against Dyson's would tell you nothing useful, so compare a business with a rival in its own market or with its own last year.
Reading a falling margin: which one moved matters
The two margins fall for different reasons, so reading them side by side points at the cause.
| What has changed | Gross margin | Net margin | What it signals |
|---|---|---|---|
| Suppliers raise prices | Falls | Falls | The product costs more to make |
| Heavy discounting | Falls | Falls | Sales are being bought with price cuts |
| Rent or wages rise | Holds steady | Falls | Overheads have risen |
| Cheaper supplier found | Rises | Rises | Direct costs have been cut |
- The gross margin touches only revenue and the direct cost of the product, so when it slides the cause sits with suppliers or with the price being charged.
- A net margin that falls while the gross margin holds steady means the trading itself is unchanged and the overheads have grown, so the owner should look at rent, wages and marketing rather than at suppliers.
Average rate of return: judging money spent on an investment
Average rate of return (ARR): the average yearly profit an investment earns, written as a percentage of the money spent on it.
A business spends £60,000 on a new machine that is expected to earn £90,000 of profit over 5 years.
ARR is found from ARR=average annual profitcost of investment×100\text{ARR} = \dfrac{\text{average annual profit}}{\text{cost of investment}} \times 100ARR=cost of investmentaverage annual profit×100.
Average annual profit comes first, from £90,0005=£18,000\dfrac{\pounds 90{,}000}{5} = \pounds 18{,}0005£90,000=£18,000.
Putting that into the formula gives £18,000£60,000×100=30%\dfrac{\pounds 18{,}000}{\pounds 60{,}000} \times 100 = 30\%£60,000£18,000×100=30%.
The machine returns 30 per cent of its cost each year on average, which can be set against another project or against the interest the £60,000 would earn sitting in the bank.
- Treat the answer with care, because it rests on forecast profits, and a forecast that turns out to be optimistic makes a weak project look strong.
- ARR also ignores when the money arrives, so a project that returns most of its profit in year five scores exactly the same as one that returns it in year one, even though the second frees up cash far sooner.
- For calculations, write the formula first, show the figures clearly and give margins or ARR as percentages.
- For ARR, calculate average annual profit before dividing by the cost of the investment.
- For interpretation or comparison, explain what the percentage means for this business and use the relevant rival, year or project.
- State the formula for the gross profit margin.
- A shop has revenue of £250,000 and net profit of £30,000, so what is its net profit margin?
- A machine costs £40,000 and is forecast to earn £50,000 of profit over 5 years, so what is its ARR?
- A business's gross margin holds steady while its net margin falls, so what has happened?
- Give one reason an ARR figure can mislead a business.
