Revenue vs. profit: how to understand gross margin

01

Separate revenue from profit

Net revenue is sales revenue after adjustments such as returns, discounts and allowances. Gross profit is net revenue less the direct cost of goods or services sold. Net profit goes further: it accounts for the other expenses and income included in the period, including operating costs and, where applicable, interest and taxes.

Gross profit is an amount. Gross profit margin expresses that amount as a percentage of net revenue: gross profit divided by net revenue, multiplied by 100. The remainder must still cover costs outside the direct cost of sales. Gross margin is not the same as net profit or cash in the bank.

02

Calculate gross margin

Hypothetical example: a business records $100,000 in net revenue and $60,000 in direct costs for the same period. Gross profit is $40,000. Gross margin is $40,000 divided by $100,000, or 40%. If other expenses total $35,000 and there is no other income or expense, net profit is $5,000. This simplified example excludes taxes and interest. Include them when they apply.

Margin uses revenue as its denominator. A markup uses cost as its denominator. In this example, the $40,000 difference is a 40% margin on revenue and about a 66.7% markup on the $60,000 direct cost. Treating the two percentages as interchangeable can lead to pricing errors.

03

Use the figures to investigate

Compare the same period and cost definitions over time. If revenue rises but gross margin falls, check the mix of products or services, discounts, direct labor and supplier costs. A change in how costs are classified can also explain the difference. Note it before comparing periods.

Look at both the percentage and the amount. A higher margin percentage may accompany lower total gross profit if sales fall. Businesses differ in what they sell and how they classify costs, so an outside benchmark is useful only when its definitions and business mix are comparable.

• Reconcile sales adjustments and direct costs to your financial records.
• Review unusual changes with the people responsible for pricing and delivery.
• Ask an accountant to help classify costs or interpret the figures when needed. This guide is general information, not financial advice.

04

Reconcile the margin to your accounts

Start with the revenue and cost-of-sales lines for the same period in the profit and loss statement. Reconcile returns, credits and discounts to net revenue, and check whether labor, freight or subcontractors are consistently classified. If an expense moved between cost of sales and operating expense, show the reclassified comparison before interpreting a margin change.