Gross income isn’t an accurate depiction of your small business earnings. Before businesses earn a cent, they pay overhead costs—ingredients to manufacture products, the wholesale price for purchasing goods, equipment needed to produce items to be sold—and to find true gross profit, expenses must be subtracted from earnings.
Total revenue is not the be all and end all of the business world. A firm that makes $1 million per year in sales but has $1 million in expenses brings in less overall than a firm with $100,000 in sales but only $10,000 in expenses. In general, profitability is measured in two slightly different ways, by calculating gross margin or gross profit.
What is gross profit?
Also referred to as net income, gross profit measures a company’s dollar amount profits after deducting its production costs. In other words, gross profit equals a business’s total sales revenue minus its costs of production, commonly known as cost of goods sold (COGS).
Using a child’s lemonade stand as an example, the children bring home $50 in total sales revenue. But before they set up shop, they spent $25 on ice, lemonade mix, sugar, lemons and paper cups. Subtracting this $25 COGS from their $50 in total sales means their gross profit for the day is $25.
What is gross margin?
Gross margin—also known as gross profit percentage or gross margin percentage—measures a company’s financial efficiency. It measures how much profit you secure per dollar of sales. More specifically, gross margin equals your gross profit divided by your total sales revenue, multiplied by 100, resulting in a percentage value.
In the lemonade stand example, since the children’s gross profit (their total sales minus their COGS) is $25, their gross margin is $25 divided by $50 (their total sales), multiplied by 100. The lemonade stand therefore has a gross margin of 50%. In other words, 50% of the lemonade stand’s sales went toward covering expenses like the sugar, cups, and lemons, leaving the other 50% for the children’s piggy banks.
Gross margin vs. gross profit
Both gross margin and gross profit are used to measure a business’s profit. The difference is gross profit is a flat number while gross margin is a percentage. Both are valuable metrics for different purposes.
Gross profit can be used:
- To determine your spending power. Working out gross profit tells you exactly how much you earn after expenses, in dollar terms, over a given period. This way, you know how much money to reinvest in your business. When it comes to buying things, a dollar figure is more useful than a percentage. For example, knowing gross profit means you’ll know how long it’ll take your business to pay off its expensive new juice dispenser.
- To look at variable costs. Gross profit also shows how efficiently you make use of your resources, such as labor, raw materials, and supplies—the costs of which fluctuate with your level of output.
On the other hand, gross margin can be used:
- For long-term planning. If your gross margin is consistent over an extended period, you know that for every dollar you earn in sales, you can reasonably predict a certain gross profit on that dollar. Knowing your gross margin can increase your operational efficiency as you better understand your business’s financial standing.
- To expand your business. While line items like variable costs and direct expenses shift over time, having a baseline for expected profits per dollar of sales gives you valuable data, which you can use to propose an expansion or request additional investment.
Here are the formulas for calculating gross profit and gross margin, respectively:
Gross profit = sales revenue – cost of goods sold (COGS)
Gross margin (%) = gross profit / sales revenue x 100
Note that you can’t calculate gross margin without knowing your gross profit—the latter depends on the former. Whereas you can calculate gross profit using only your total sales and COGS, gross margin requires you to know your gross profit first, which you then divide by your total sales revenue.
Gross profit is measured as a number, while gross margin is a percentage. Without knowing a company’s other financial metrics (such as net revenue), gross profit can be hard to put into perspective. A company’s gross profit figure means little unless you know the total revenue for the same period.
For example, $25 in gross profit looks very different depending on whether the lemonade stand sold $50 or $500 worth of drinks. In both cases, the gross profit is the same ($25). Gross margin, on the other hand, offers more insight into the financial health of your operation, because it provides a proportion rather than a fixed dollar figure. If the lemonade stand made $25 by selling $50 worth of drinks, the gross margin is 50%; if it sold $500 worth of drinks, the gross margin is 5%.
Gross margin and gross profit FAQ
What does gross margin measure?
Gross margin measures a company’s financial efficiency, i.e., how much profit it secures per dollar of sales.
What does gross profit measure?
Gross profit measures a company’s profits in a dollar amount after deducting its production costs.
What’s the difference between gross margin and gross profit?
Gross profit is the money left over after a company’s costs are deducted from its sales. Gross margin is a company’s gross profit divided by its sales and represents the amount earned in profit per dollar of sales. Gross profit is stated as a number, while gross margin is stated as a percentage.
Is calculating gross margin and gross profit the same?
No. Gross margin equals the gross profit divided by the sales revenue, multiplied by 100. Gross profit equals the sales revenue minus the cost of goods sold (COGS).