Net profit margin and gross profit margin are both profitability metrics that allow managers and investors to evaluate how profitable a business is. However, gross profit margin allows the analyst to hone in on the expenses incurred to produce or manufacture products. If a company doesn't sell products or physical goods but instead sells services, it doesn't have a gross profit margin.
Net Profit Margin
Net profit margin compares after-tax profit to total revenue. Net profit is what's left of business revenue after deducing business expenses. Common business expenses include cost of goods sold, rent, salaries, insurance, benefits, utilities, office supplies, depreciation and taxes. The higher net margin is, the more net profit a company keeps relative to revenue.
To calculate net profit margin, divide net profit by revenue. For example, a company with $500,000 in revenue and $100,000 in net profit has a net profit margin of 20 percent.
Gross Profit Margin
The gross profit margin formula is the same as the net profit formula except that gross profit is used in lieu of net profit. Gross profit is revenue less cost of goods sold. Cost of goods sold are the specific costs incurred to produce the products sold during the accounting period. The cost of direct labor, direct materials and manufacturing overhead are all part of the cost of goods sold. Because general business expenses aren't deducted, gross profit is always larger than net profit. The higher the margin, the more revenue a company makes relative to the product's cost.
To calculate gross profit margin, divide gross profit by revenue. For example, if revenues are $500,000 and gross profit is $300,000, the gross profit margin is 60 percent.
Differences and Applications
Net profit margin illustrates a company's overall profitability while gross profit margin hones in on product profitability.
The two metrics can be used in conjunction to pinpoint where a company might be incurring unnecessary costs. For example, if net profit margin is low but gross profit margin is relatively high, the excess expense is probably from general and administrative costs. If net profit margin is low and the gross profit margin is also low, it's possible that there's waste and inefficiencies in the manufacturing and production process that are driving down both metrics.