Gross margin and net income have an indirect, but strongly connected, relationship in a company's profit structure. While optimized net income is the bottom-line financial objective of for-profit companies, strong gross margin is a signal of financial health that contributes to ongoing profitability.
Calculate Gross Margin
The first level of income a company looks at is gross income. This income is derived by subtracting costs of goods sold in a period from revenue. Gross margin is then figured by dividing gross profit by revenue. If you make $60,000 in gross profit on $150,000 in revenue, for instance, your gross margin is 40 percent.
Achieving stable and strong gross margin shows efficiency in converting revenue into gross income. There are no general rules on "good" margin levels, as they vary by industry. Forty percent margin in the energy sector is impressive as of April 2015, because the trailing 12-month sector average was 31.99 percent, according to CSI Market. However, 40 percent is relatively low in transportation, where the 12-month trailing average was 61 percent gross margin. In addition to meeting or exceeding industry or sector margins, improving your company's gross margin over time is a common financial goal.
Turning Gross Margin into Net Income
Before you get to net income on an income statement, subtract operating expenses from gross profit, and then account for irregular revenue and expense activities. However, gross margin carries strong weight, for better or worse, in arriving at a particular net income.
High gross margin means your business is efficiently generating gross profit on revenue. Strong gross profit preserves more revenue to cover operating expenses. Leaving out irregular activities, paying off your overhead with gross profit and retaining operating profit is essential to long-term financial success. In contrast, a low gross margin puts your business in the compromising position of trying to minimize operating and non-operating expenses to achieve net income, or to minimize net loss. Therefore, optimizing the relationship between your pricing strategies and inventory costs is significant to profitability.
Neil Kokemuller has been an active business, finance and education writer and content media website developer since 2007. He has been a college marketing professor since 2004. Kokemuller has additional professional experience in marketing, retail and small business. He holds a Master of Business Administration from Iowa State University.