Gross, operational and net profit margin: what’s the difference?
Gross, operational and net profit margin: an overview
Gross profit margin, operating profit margin, and net profit margin are the three primary margin analysis metrics used to analyze a company’s income statement activities.
Each margin individually gives a very different perspective on the operational efficiency of the business. Taken together, the three margins taken together can provide insight into a company’s operational strengths and weaknesses (SWOT). Margins are also useful for comparing competitors and identifying growth and loss trends compared to past periods.
Key points to remember
- An income statement is divided into direct and indirect charges and into interest and taxes.
- Gross profit, operating profit and net profit margins are important metrics for analyzing an income statement.
- Each measure of profit margin indicates the amount of profit per dollar of a company’s turnover.
Overall, margin analysis metrics measure a company’s efficiency by comparing benefits to costs in three different places on an income statement.
Gross profit margin analyzes the relationship between gross sales and direct costs of sales. This comparison constitutes the first part of the income statement. Companies will have different types of direct costs depending on their activity. Companies involved in the production and manufacture of goods will use the cost of goods sold measure, while service companies may have a more general rating.
Overall, gross profit seeks to identify the efficiency with which a company manufactures its product. The gross profit margin calculation is gross profit divided by total revenue. In general, it is better to have a higher gross profit margin because it represents the total gross margin per dollar of sales.
Operating profit margin
Operational efficiency is the second section of a company’s income statement and focuses on indirect costs. Businesses have a wide range of indirect costs that also affect the bottom line. Some commonly reported indirect costs include research and development, marketing campaign expenses, general and administrative expenses, and depreciation and amortization.
The operating profit margin examines the effects of these costs. Operating profit is obtained by subtracting operating expenses from gross profit. The operating profit margin is then calculated by dividing the operating profit by the total sales.
The operating result shows the ability of a company to manage its indirect costs. Therefore, this section of the income statement shows how a company invests in areas that it believes will help improve its brand and business growth through multiple channels. A business can have a high gross profit margin but a relatively low operating profit margin if its indirect expenses for things like marketing or capital investment allowances are high.
The net profit margin
Net profit margin is the third and final measure of profit margin used in income statement analysis. It is calculated by analyzing the last section of the income statement and a company’s net profit after accounting for all expenses.
Net profit margin takes into account the interest and taxes paid by a business. Net profit is calculated by subtracting interest and taxes from operating profit, also known as profit before interest and taxes (EBIT). The net profit margin is then calculated by dividing the net profit over the total turnover.
Net income highlights a company’s ability to manage its interest and tax payments. Interest payments can take several varieties. Interest includes interest that a company pays to stakeholders on debt for capital instruments. It also includes all interest earned on short and long term investments.
Taxes are charged at a flat rate for corporations. As a result of the 2017 Tax Cuts and Jobs Act, the corporate tax rate was reduced from 35% to 21%. Just like individuals, corporations should also identify and account for corporate tax breaks that come in the form of credits, deductions, exemptions, etc.
The net profit margin of a business shows how the business manages all of the expenses associated with the business. In the income statement, expenses are generally broken down into direct, indirect and interest and taxes. Companies seek to individually manage spending in each of these three areas.
By analyzing the comparison of gross, operational and net profit margins, industry analysts can get a clear idea of a company’s operational strengths and weaknesses.
Business and commercial factors may affect each of the three margins differently. Consistently, if direct selling expenses increase across the market as a whole, a business will have a lower gross profit margin which reflects higher selling costs.
Businesses can go through different growth cycles that result in higher operating and interest costs. A business may invest more in marketing campaigns or capital investments that increase operating costs for a period that can reduce operating profit margin. Companies can also raise capital through debt, which can reduce their net profit margin when interest payments increase.
Understanding these different variables and their effects on margin analysis can be important for investors when analyzing the value of business investment.