# What is the relationship between gross margin and profit margin?

Gross margin and profit margin are two measures used to determine the strength of a company's earning power. Gross margin measures the amount of revenue a business generates after deducting the cost of goods sold. This is a top-level measure of a company's sales numbers. Profit margin measures net profit in relation to total sales during a period. The profit margin represents the amount of money from total sales that a company can reinvest in its operations.

A basic formula for gross margin is revenue minus cost of goods sold divided by revenue. This returns a percentage that indicates how much revenue is paid for the cost of goods sold. For example, a company has \$750,000 in sales and \$450,000 in cost of goods sold. This results in a gross margin of 40%; therefore, \$0.60 of every dollar goes to pay for the cost of goods sold. The relationship between gross margin and profit margin starts with this calculation.

The markup formula is net profit divided by total profit. For example, the company in the example above has a net income of \$75,000 USD with a total income of \$750,000 USD. The profit margin is 10%. The measure determines that for every \$1 in sales, \$0.10 will generate a profit for the company. Companies often compare their gross margin and profit margin to determine the drop in gross profit after expenses.

Both the gross margin information and the profit margin formula come from information on a company's income statement. Companies prepare this statement every month. This allows a comparison between these two formulas frequently. Owners and managers can compare these formulas to determine an upward or downward trend in profitability. Companies can also use the information from these formulas as a benchmark against other companies or the industry standard.

Both gross margin and profit margin can lead to incorrect numbers, sometimes stemming from poorly prepared income statements. The income statement also includes non-cash expenses such as depreciation and amortization. This reduces a company's profit for a certain period. The markup reflects a smaller percentage, giving an inaccurate value.

External stakeholders are often most interested in these numbers. They can easily calculate information from published financial information. Using this data, investors can determine whether they want to remain invested in the company or move on to more profitable investments.

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