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The Differences Between Gross Margin & Gross Profit
Both gross profit and gross margin are used to determine a company’s profitability, but one is a measure of expenses while the other is a measure of operational efficiency. Gross profit is the total dollars remaining for business operations after subtracting the cost of sales from total revenue, and gross margin is the percentage of those dollars compared to total revenue.
Gross profit matters more when expanding or making new investments since it’s how much money is available to run your business. Gross margin is what to focus on to get the most from every dollar of revenue for situations like a flat or declining industry or recessions.
Gross margin and gross profit are directly related based on their formulas:
- Gross profit = Revenue – Cost of Goods Sold (COGS)
- Gross margin = Gross Profit / Revenue
In a perfect world where you can raise prices without losing volume, while simultaneously cutting product costs, you would grow gross profit and gross margin at the same time. That’s not always possible though, so we’ve created this guide for when to focus on gross profit or gross margin and situations when both are helpful.
Situations for When to Focus on Gross Profit
Focus on gross profit in situations where revenue can grow and you want to expand or make new investments, because more gross profit gives you more dollars for advertising, salaries, and other operating expenses needed for growth, even if gross margin declines.
If you own a manufacturing company, where cutting the price by 10% gets you another customer so you can produce at full capacity, the higher volume makes up for the lower price per unit and gross profit grows.
| Capacity | Units | Price | Cost per Item | Revenue | COGS | Gross Profit | Gross Margin | |
| Current | 80% | 800,000 | $12.00 | $5 | $9,600,000 | $4,000,000 | $5,600,000 | 58% |
| Future | 100% | 1,000,000 | $10.80 | $5 | $10,800,000 | $5,000,000 | $5,800,000 | 54% |
| -10% | $1,200,000 | $1,000,000 | $200,000 | -4% |
Gross margin goes down 4% because your cost per item stays flat while you cut price, but the extra volume means revenue grows by $1.2 million and you make another $200K in gross profit. You can drop the extra gross profit to the bottom line or use it as a down payment on an equipment financing loan to increase your capacity if your business plans include growing or you have landed a new client and need to scale production to meet the new levels of customer demand.
Times to Focus on Gross Margin
The time to focus on gross margin is when a declining industry prevents you from growing or when you’re near full capacity and want to make more profit but not make investments to grow your top line.
Imagine a recession hits a year after you reached full capacity from the previous example. Customers will order 10% less no matter what you charge, so cutting the price isn’t an option and 90% production capacity is the most you can sell. This is the time to focus on gross margin by renegotiating with your suppliers for a 10% discount to lower your cost per item.
| Capacity | Units | Price | Cost per Item | Revenue | COGS | Gross Profit | Gross Margin | |
| Current (Pre-recession) | 100% | 1,000,000 | $10.80 | $5 | $10,800,000 | $5,000,000 | $5,800,000 | 54% |
| Future (In recession) | 90% | 900,000 | $10.80 | $4.50 | $9,720,000 | $4,050,000 | $5,670,000 | 58% |
| -10% | -$1,080,000 | -$950,000 | -$130,000 | +4% |
Gross margin grows 4 percentage points, and the recession causes gross profit to be $130K lower, but the focus on gross margin offsets the loss and sets you up for success coming out of the recession. As the economy recovers, you’ll be able to increase price and volume at the same time, so both gross profit and gross margin grow at the same time.
Gross Margin and Gross Profit Grow Together
Gross margin and gross profit can grow together when you have the power to raise prices and increase production at the same time. This could be when you’re coming out of a recession or when your industry is growing faster than the competition can keep up.
Your cost per item would still be $4.50 since you renegotiated supplier contracts during the recession, but as customer orders recover, you raise price by 5% while increasing capacity to 93%.
| Capacity | Units | Price | Cost per Item | Revenue | COGS | Gross Profit | Gross Margin | |
| Current (In recession) | 90% | 810,000 | $10.80 | $4.50 | $8,748,000 | $3,645,000 | $5,103,000 | 58% |
| Future (Post recession) | 93% | 837,000 | $11.34 | $4.50 | $9,491,580 | $3,766,500 | $5,725,080 | 60% |
| +5% | $743,580 | $121,500 | $622,080 | +2% |
The price increase together with higher volume grows revenue $743,580 while keeping cost per item flat so your gross profit increases $622,080 while gross margin also grows by 2 percentage points and you still have 7% capacity left for future growth.
Gross margin and gross profit are related since they both measure how much money is left to run your business after subtracting product costs from revenue. They’re different in that gross profit tells you the total number of dollars you have remaining after subtracting COGS from revenue, whereas gross margin tells you the percentage of dollars left when dividing gross profit by revenue. When expanding, it’s better to focus on gross profit even if the margin falls because you’ll have more money to make necessary investments. If growth isn’t possible or isn’t a priority, focusing on gross margin helps you keep the most money from every dollar of sales.
QuickBridge does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
