The three margins
- Gross margin = (revenue − cost of goods sold) ÷ revenue. What each sale leaves after the direct cost of producing it.
- Operating margin = (gross profit − operating expenses) ÷ revenue. What the business makes from operations, before financing and tax.
- Net margin = (operating profit − interest − taxes) ÷ revenue. The bottom line.
With $500,000 of revenue, $200,000 of cost of goods, $180,000 of operating expenses and $30,000 of interest and taxes: gross margin is 60%, operating margin 24% and net margin 18%.
Which one to watch
Gross margin tells you whether the product itself makes money and sets the ceiling on everything below it; it is the number to use for pricing, ad spend and break-even. Operating margin shows whether the company can carry its own overhead. Net margin is what is left for the owners. If gross margin is healthy but net margin is thin, the problem is overhead, not price.
To set a price that hits a target margin, use the markup calculator; to see how much you need to sell to cover your fixed costs, the break-even calculator.