Gross, Operating and Net Profit: What Each One Tells You

Walking down the income statement

• Revenue (also called sales or turnover) is the money earned from customers.
• Cost of goods sold (COGS) is the direct cost of what you sold: materials, stock bought for resale, and the labor that makes the product.
• Gross profit is revenue minus COGS.
• Operating expenses are the costs of running the business that are not tied to a specific product: rent, wages for office and sales staff, marketing, software, insurance.
• Operating profit is gross profit minus operating expenses. It is earned before interest and income tax.
• Net profit is what remains after interest and tax are also deducted.

Exactly which costs sit in COGS and which in operating expenses varies between industries and accounting policies, so compare your own figures against like-for-like definitions.

A worked example

A small business reports annual revenue of 250,000 and COGS of 140,000. Operating expenses are 78,000, interest is 4,000, and the tax rate on profit is 25%.

margin = profit ÷ revenue × 100The same formula works for gross, operating and net profit.

Of every 100 in sales, 44 is left after making the product, 12.80 after also running the business, and 8.40 after financing and tax.

What each margin tells you

Gross margin is about the product and its pricing. If it falls, either your costs of supply have risen, you are discounting more, or your sales mix has shifted toward lower-margin items. A healthy gross margin has to be large enough to cover everything beneath it.

Operating margin is about the whole operation before financing and tax. It is often the best measure of how efficiently the business runs, because it is not distorted by how it is funded or by tax rules. It is also known as return on sales, and a return on sales calculator works it out from operating profit and revenue.

Net margin is what the owners are left with. It is the figure that matters for dividends or reinvestment, but it can swing for reasons unrelated to day-to-day trading, such as a one-off tax charge or a change in loan interest.

How a small change flows down

Operating expenses and interest do not shrink when your product costs rise, so a change at the top of the statement lands almost entirely on the bottom line. Suppose COGS in the example rises from 140,000 to 145,000 while everything else is unchanged.

Gross profit falls to 105,000, a gross margin of 42%. Operating profit falls to 105,000 − 78,000 = 27,000, or 10.8% of revenue. After 4,000 of interest, profit before tax is 23,000, tax at 25% is 5,750, and net profit is 17,250, a net margin of 6.9%.

A two-point drop in gross margin, from 44% to 42%, has cut net profit by 3,750, or about 17.9%. That is why owners watch the gross margin so closely: small changes in it are magnified further down.

Common mistakes

• Confusing gross profit with revenue. "Gross" here means before operating expenses, not before costs altogether.
• Leaving out the owner's pay. If you work in the business but take no wage, your profit looks higher than it really is.
• Mixing percentages of different bases. A margin compares profit to revenue, whereas markup compares it to cost. See why a 30% markup is not a 30% margin.
• Reading one period in isolation. A single month can be skewed by timing. Trend over several periods is more informative.

To calculate gross margin from any revenue and cost, use the margin calculator.

This article is general education, not accounting, tax or financial advice. Definitions and rules differ by country and business type, so ask a qualified professional about your own accounts.