Assessing the financial health of your startup is something you need to do frequently as your business moves through different growth stages. Gross margin and net margin are two of the key profitability ratios for measuring your profits against your revenue over a set period of time. This gives you a good snapshot of your company’s wellbeing.
In this post, we’ll compare gross margin vs. net margin to show how they differ, how to calculate each of them, and why each metric is important for your SaaS business.
What is gross margin?
Gross margin, also known as “gross profit margin,” is a metric that gives you a general overview of how efficiently your business is running.
When you calculate gross profit margin at regular intervals and look at your numbers over time, it gives you an indication of how well your processes and systems are working. If your margin percentages remain stable, it’s a sign that your business is in good health. If you can see gross profit margin wildly fluctuating or decreasing at every calculation interval then you need to examine why this is happening so you can fix any weak spots in your company operations.
Your gross profit margins can be compared against those of your competitors to see if your company is performing at the same levels. If your margins are better than theirs, it means your operations are more efficient. If the margin percentage is lower, then it’s time to look at what you need to change in terms of your sales, pricing, and expenses to get up to speed with the competition.
If you’re an early stage startup, don’t panic if your gross margins are below the industry average. It can take time to not only get your pricing, sales, and operations in alignment, but also to create the efficient processes needed to give you healthy margins.
How to calculate gross profit margin
The gross profit margin formula is simple to calculate. It’s always expressed as a percentage, and takes into account your net sales revenue minus the cost of products sold over a set interval – like so:Gross Profit Margin=(Total Revenue–Cost of Goods Sold)x
Say your total revenue from sales is $20,000 for a quarterly period, and your cost of products sold (or subscription sign ups) is $15,000 (factoring in all the necessary direct costs that you incur over this time). Your gross margin would look like this:
$20,000 – $15,000 = $5,000
Your gross profit margin is $5,000 for this quarter in a dollar value. To check how you’re doing in a percentage value, you need to do another quick calculation and divide your gross margin amount by total revenue, then times by 100.
$5,000 / $20,000 x 100 = 25%
For most industries, this margin would mean you’re running your business efficiently and have a healthy, stable startup.
If you’re a SaaS startup, “products sold” should factor in items like:
Any third party apps you need to run your business
Customer success costs
You might notice that some companies, even global giants, are running tiny (or even negative) gross margins. This is usually done on purpose as part of their growth strategy. Amazon, for example ran at negative margins for over a decade and is only barely scraping into positive digits now at 3.8% – compared to 45% for Facebook.
What is net margin?
Net margin, also known as “net profit margin,” is a metric that measures how much of a company’s net income, or profit, is generated from revenue. Net profit margin is defined as the percentage of revenue that is turned into profit after all expenses.
Again, this varies by industry and you can compare your net profit margin percentage to your competitors to gauge how well you’re doing. The higher your net margin is in comparison to the average figures, the better it is for your business.
How to calculate net profit margin
The formula for this calculation is revenue minus the cost of goods sold, operating expenses, other expenses, interest (e.g. on debt), and taxes. Again, this is divided by total revenue and multiplied by 100 to get your margin percentage, so it looks like:Net Profit Margin=Net Incomex
Your net margin can be negative or positive, with negative percentages showing where your company failed to be profitable over a certain timeframe.
Say your company makes $10,000 in sales for the quarter. Your products cost you $8,000 and you had to factor in costs for overheads and taxes of $1,000.
Your calculations to reach the net margin percentage would look like this:
$10,000 – ($8,000 + $1,000) = $1,000 (this is your net income)
$1,000 ÷ $10,000 = 0.1
0.1 × 100 = 10%
In this example, your net profit margin is 10%, which tells you how much of your total sales revenue is profit.
Some companies opt for sales and pricing strategies like lowering their net profit margin and driving exponentially more sales to increase their total net profits.
This looks great on paper – but unless you’re Walmart, a low cost/high volume tactic can be a risky approach that serves only to damage your brand image and position you as a “cheap” company (also a little like Walmart!).
Gross margin vs. Net margin
Much like the difference between gross profit and net profit, comparing gross margin vs. net margin is most easily understood when you think of them as a single metric, where the only difference is whether you want your calculation to consider all business expenses or just the cost of goods sold (COGS). Your net margin differs from gross margin in that it takes into account how much profit you keep after tax for every dollar you generate in revenue, while gross margin only takes into account how much profit you keep after subtracting COGS.
Why you should track gross margin and net margin
Gross margin and net margin can tell you a lot about your company’s current profitability and position in the wider marketplace.
These metrics should be assessed with regard to the stage of growth of your business. Low and shaky margin percentages for early-stage startups are normal, as it can take time to build and run an efficient operation.
As always, these two metrics should not be looked at in isolation. They are part of your essential metrics stack that you need to examine as a whole to give you a clear picture of the growth of your business.
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