What is the Difference Between Gross Margin and Gross Profit Margin?
Why should a business owner care about the difference between gross margin and gross profit margin?
What even is the difference?
Maybe you’ve reviewed your financials and seen the terms "gross margin" and "gross profit margin" pop up, but you weren’t quite sure what they mean or how they differ.
You’ve got a business to run, leave that to the accountants!
But understanding the difference between gross margin and gross profit margin can be extremely helpful for making business decisions. It can help you set the right prices, analyze your profitability, and even uncover hidden growth opportunities.
So, let's break down the jargon and explore why these concepts are so important for your business's financial health.
Defining the Difference Between Gross Margin and Gross Profit Margin
Let's start with the basic definitions.
Gross Margin
The gross margin is used to understand the direct profitability of products or services in absolute terms.
It’s the absolute dollar amount of revenue minus the cost of goods sold (COGS).
Gross Margin = Revenue − Cost of Goods Sold
The gross margin helps in assessing the profitability of individual products, making it easier to determine which products generate the most profit in absolute dollars.
For example, if you sell a handmade scarf for $50 and it costs you $20 in materials and labor to make, your gross margin is $30.
Gross Margin = $50 − $20 = $30
Gross Profit Margin
Gross profit margin is the percentage of revenue that exceeds the cost of goods sold (COGS).
It shows how much money you've made before deducting all of your overhead costs, sales costs, and other expenses.
Gross Profit Margin = ((Revenue - Costs of Goods Sold) / Revenue) x 100
It’s used to understand the profitability of products or services as a percentage of sales.
Gross profit margin provides a relative measure of profitability, which is useful for comparing performance over time or against industry benchmarks.
Using our very simple scarf example, the gross profit margin would be:
(($50 - $20) / $50) x 100 = 60%.
This means that 60% of every dollar you earn from selling the scarf is gross profit.
So, What Exactly is the Difference Between Gross Margin and Gross Profit Margin?
While both are indicators of the profitability of what you’re selling, gross margin is expressed as a dollar amount, and gross profit margin is a percentage.
Gross margin is absolute and helps you with individual product strategies, while gross profit margin is relative, and lets you compare performance.
Let’s explore a bit more so you can see their value and usage.
Why the Difference Matters
Now that we've defined the terms, let's see why knowing the difference between gross margin and gross profit margin is important.
Decision-Making
Gross margin helps in making decisions about pricing and cost control on a per-product basis.
Gross profit margin assists in decisions such as evaluating overall business performance and comparing different business units or periods.This is important when choosing the right financial goals for a business.
Comparative Analysis
Gross margin is helpful for comparing the absolute profitability of different products or services.
Gross profit margin standardizes profitability across different sales volumes and cost structures, making it easier to compare performance across different periods, products, or companies regardless of their size. This can be particularly insightful when tracking your accounting KPIs.
Scalability
Gross margin provides insight into the actual profit made from sales, which is critical for understanding the cash flow and funding needs for business expansion.
Gross profit margin is more useful for assessing the scalability of a business. A higher percentage indicates better potential for scalability and growth, implying a more efficient cost structure. This is helpful for longer term planning, such as when leveraging financial forecasting for decision-making.
Examples of Applying the Difference Between Gross Margin and Gross Profit Margin in Different Industries
Let's look at a few examples to see how gross margins play out in different businesses:
Tech Startup
Gross Margin: A tech startup sells a software subscription for $200 per year. The cost to provide the service, including server costs and customer support, is $50 per year. The gross margin is $150 ($200 - $50).
Knowing the gross margin ($150 per subscription) helps the startup manage its cash flow effectively.
The company can estimate how much cash is generated from each subscription sold, which is critical for covering operating expenses and investing in growth.
Gross Profit Margin: The same startup has a gross profit margin of 75% ($150 / $200 x 100).
This percentage helps investors compare the startup's profitability relative to its sales, showing how efficiently the company turns revenue into profit.
Retail Clothing Store
Gross Margin: A retail clothing store sells a jacket for $100. The cost of goods sold (including manufacturing and shipping) is $40. The gross margin is $60 ($100 - $40).
This helps the store identify which products generate the most profit in absolute terms. This insight is critical for inventory management and determining which products to stock more heavily.
Gross Profit Margin: The gross profit margin is 60% ($60 / $100 x 100).
This percentage is useful for comparing the store's profitability to other retailers or to its own performance over different seasons.
Restaurant
Gross Margin: A restaurant sells a meal for $25. The cost of ingredients and preparation (COGS) is $10. The gross margin is $15 ($25 - $10).
This can help in identifying the most profitable items on the menu. The restaurant can optimize its menu, focusing on high-margin dishes to increase overall profitability.
Gross Profit Margin: The gross profit margin is 60% ($15 / $25 x 100).
This helps the restaurant compare its efficiency in different locations or with competitors, regardless of the volume of meals sold.
Manufacturing Company
Gross Margin: A manufacturing company produces a gadget for $70 and sells it for $120. The gross margin is $50 ($120 - $70).
This helps the company identify high-cost areas in the production process. By focusing on reducing these costs, the company can increase its overall profitability.
Gross Profit Margin: The gross profit margin is 41.67% ($50 / $120 x 100).
This percentage helps the company evaluate its production efficiency and profitability compared to other manufacturers.
We’re Here to Help You Through the Jargon
Understanding the difference between gross margin and gross profit margin is helpful for any business owner who wants to maximize profitability and make informed decisions. By tracking this information regularly, you can uncover valuable insights that can help your business thrive.
If you need help analyzing your gross margins or making sense of your financial data, Accounting Made Accessible is here for you. We specialize in making accounting approachable and actionable, so you can focus on what you do best – running your business.
Book a free strategy call today and let us help you uncover the financial insights that will drive your business forward.