Gross Profit vs. Gross Margin: How Do They Differ?
Updated September 21, 2023.
Thinking of starting your own small business or looking at improving your current small business's profitability? Getting to know and understand the key difference between gross profit and gross margin will help you assess your profitability more accurately.
The simple fact is that gross profit and gross margin may be closely related, but they differ from themselves in terms of what they measure as much as they differ from net and operating profit margins. Read on to learn more or check out this guide which covers how to calculate net profit margin and much more.
What Is Gross Profit?
Your gross profit is the total amount of profit that your company makes on the sale of a product. In other words, it is the amount you have left over after you have covered your direct production costs. Let's look at a simple example:
Net sales revenue – COGS (cost of goods sold) = gross profit
You are a baker. You sell a wedding cake for $50 (net sales revenue). The cost of the ingredients equals $25 (COGS). Your gross profit is equal to $25.
Your net sales revenue is the total amount you generated from your sales over a period. Net sales includes the deductions you need to make as a result of goods that have been returned, as well as discounts you have received from your suppliers. It is often referred to as your "top line" because you'll find this amount on the top line of your income statement. Once your costs have been deducted from your revenue, you get your net income—also referred to as your "bottom line."
The COGS (cost of goods sold) refers to your direct costs for producing your products. Some examples of COGS include the materials used, such as the ingredients for your wedding cake and the labor costs for mixing ingredients and icing it.
» Discover how you can calculate gross profit percentage
What Is Gross Margin?
Your gross margin is calculated as a percentage of how much your sales revenue exceeds the total cost of making the sale. Let's look at another practical example:
Gross profit / net sales revenue x 100
Your wedding cake's gross profit is $25. In this simple example, your net sales revenue is $50. Therefore, your gross margin is $25 / $50 x 100 = 50%
Which Should You Use?
The short answer? You should use both of these financial metrics. Since gross profit and gross margin are not the same calculations and measurements, they will tell you two slightly different but equally important stories about your business.
Gross profit gives you a basic idea of how much your business makes, while gross margin digs a little deeper. Your gross margin will tell you how well your company is generating revenue compared to your production costs for both products and services. The higher your percentage margin, the more effective your company is at managing the generation of revenue for each dollar you spend. It also makes it easier for you to compare your business to competitors, whether local or international. You can then track and benchmark your gross margin against other companies over a longer period to pick up on trends within your specific industry.
The two terms may have similarities but understanding their differences is what could make a difference to your bottom line.