Gross and net margin: formulas and a worked example
Gross profit is revenue minus the defined cost of sales; the gross margin percentage is gross profit divided by revenue, multiplied by 100. Net profit is the amount remaining after all recognised expenses; the net margin percentage is net profit divided by revenue, multiplied by 100. In our fictional example, €1M of revenue produces €350,000 of gross profit, or 35%, and €50,000 of net profit, or 5%.
For owners of SMEs and startups, understanding margins should support decisions: which price to review, which contract to renegotiate, which expense to examine. The calculation becomes useful when everyone uses the same scope. Profit in euros, a percentage of revenue and a percentage of cost answer different questions.
Gross profit and gross margin: amount and percentage
Gross profit = revenue minus cost of sales. Gross margin percentage = gross profit divided by revenue, multiplied by 100. The percentage is undefined when revenue is zero. The amount shows what remains to cover other expenses; the percentage helps compare sales of different sizes.
For a distributor, gross profit compares goods revenue with the cost of the goods sold, taking inventory into account. For a services business, define the delivery costs included, such as staff assigned to projects and external production providers. Practices can differ between businesses. Document your method and use the same scope for comparisons.
A fictional example: from 35% gross margin to 5% net margin
Consider a fictional distributor over one year, using simplified assumptions. Revenue is €1,000,000. The cost of goods sold is €600,000, plus €50,000 of freight and packaging allocated to those sales. Under our chosen scope, total cost of sales is €650,000.
- Gross profit: €1,000,000 less €650,000 = €350,000.
- Gross margin: €350,000 divided by €1,000,000, multiplied by 100 = 35%.
- Overhead: €250,000. EBITDA in this simplified example: €100,000.
- Depreciation: €20,000. Interest: €15,000. Assumed tax: €15,000.
- Net profit: €100,000 less €20,000, less €15,000, less €15,000 = €50,000.
- Net margin: €50,000 divided by €1,000,000, multiplied by 100 = 5%.
The €15,000 tax expense is an assumption, not a tax rule. This example does not describe a client. Net profit is an accounting result, not the available bank balance: receipts, inventory, investment and loan repayments also follow their own timing.
Margin versus markup: choose the right denominator
Margin expresses profit as a share of the selling price, while markup expresses it as a share of cost. An item bought for €50 and sold for €100 earns €50: 50% of the selling price or 100% of cost. Always label the denominator in your dashboard.
To target 30% of the selling price with a cost of €70, divide €70 by 0.70: the price is €100. Adding 30% to cost gives €91; the €21 profit is then about 23.1% of the selling price. These calculations assume an unchanged cost scope and no other deductions from the sale.
Direct and variable costs: two different classifications
A direct cost can be assigned to a product or project. A variable cost changes with activity volume, within the scope and period being considered. The salary of an employee assigned to a project can be direct while remaining fixed in the short term. The classifications are not interchangeable.
Contribution is revenue less variable costs; the contribution margin rate divides that amount by revenue. The break even calculation uses this rate, not automatically the gross margin percentage. Check the classification before deciding whether additional sales cover your costs.
Check the margin on five contracts
- Start with invoiced revenue after discounts, credit notes and returns, for a defined period.
- Reconcile consumed purchases, external delivery work, production time and attributable payroll using a consistent method.
- Identify freight, commissions and payment fees. Distinguish costs included in gross profit from those deducted later when assessing contract profitability.
- Avoid counting a cost twice. Document estimates and missing data.
- Compare expected and actual margins, then choose an action: review pricing, the scope of work or delivery organisation.
This review supports profitability analysis by customer. It assumes neither a percentage of unprofitable contracts nor a guaranteed improvement. Before discontinuing work, also examine the costs that can actually be avoided, the capacity released and contractual commitments.
Compare margins on a consistent basis
Start with your own periods and activities, using the same calculation rules. Explain changes in prices, costs, volume and sales mix. An industry figure is useful only when its source, year, population and definition are comparable to yours.
Rising revenue with a falling gross margin percentage does not, by itself, prove that growth destroys value. Also examine gross profit in euros, additional overhead, capacity requirements and cash receipts. Positive net profit with less cash may reflect working capital, investment, debt repayments or distributions.
A monthly routine that supports decisions
Each month, reconcile invoicing, production and accounting data. Update margins by activity and customer, explain material differences, then assign an action and a review date. The dashboard should show what you can change, not merely display a percentage.
Definition references in French: Bpifrance Création on gross profit from goods sold, margin versus markup and break even.
Move from margin percentages to contracts worth reviewing
An overall margin can stay stable while some customers consume more time, rework or external delivery. Match net sales with the costs of the same work. Keep contribution in currency beside the percentage: a better rate on much lower volume may leave less to cover fixed costs.
Choose a contract or offer, document assigned costs and test different pricing or scope. Then check actual contribution and collections.
Key points
- Separate profit in euros from margin as a percentage of revenue.
- Define the cost of sales before comparing products, customers or periods.
- Direct costs are not necessarily variable: staff assigned to a project may remain a fixed cost in the short term.
- Margin uses the selling price as its denominator; markup uses cost.
- Review five contracts using net invoicing, production time and attributable costs before deciding what to change.
Frequently asked questions
How does gross profit differ between distribution and services?
For distribution, gross profit is goods revenue less the cost of the goods sold. For services or manufacturing, the figure depends on the defined cost of sales. Specify that scope before comparing two businesses.
Are all direct costs variable?
No. An employee assigned to a project can be a direct cost while their salary remains fixed in the short term. Gross profit and contribution can therefore differ. The break even calculation uses the contribution margin rate.
What net margin should we target?
There is no universal target for SMEs and startups. Examine your business model, risks, investment needs and the trend in your results. Any industry comparison needs relevant definitions and a comparable population.
Why is cash falling when net profit is positive?
Profit and cash follow different timing. Rising inventory, later customer payments, investment, loan repayments or distributions can reduce available cash. Reconcile profit with a cash forecast before drawing a conclusion.
Which changes would improve your profitability?
See how to compare pricing, costs and volume before deciding where to act.
Find ways to improve profitability