Gross margin is the difference between revenues and the cost of goods sold, which leaves a residual margin that is used to pay for selling and administrative expenses. Net margin is the residual earnings left after all expenses have been deducted from revenues. This means that the following key differences exist between the gross margin and net margin:
- Income statement location. The gross margin is located mid-way down the income statement, immediately after the cost of goods sold line item. Net margin is located at the bottom of the income statement, following all expense line items.
- Size. The gross margin is always larger than the net margin, since the gross margin does not include any selling and administrative expenses.
- Tax effect. The gross margin is not net of any income tax expense, while the net margin does include the effects of income taxes.
- Type of cost inclusions. The gross margin is more likely to incorporate a high proportion of variable expenses, including the direct materials required to generate sales. The net margin contains a much lower proportion of variable expenses, since it also includes selling and administrative expenses, many of which are fixed costs.
The gross margin and net margin are both considered critical to the financial health of a business, so both are closely watched on a trend line. Any drop in either measurement will likely trigger a detailed investigation by management.