Gross to Net — A Guide to Margins

What's your margin?

Does anyone ask what your margins are or tell you to watch your margins? What does that actually mean?

Understanding margin(s) starts with which one you're looking at. Here are the "big 4" that are worth your time:

1. Product margin
2. Gross margin
3. Operating margin
4. Net margin

A "margin" is simply the difference between the price and cost of something. It gets interesting when we change the definition of "cost" to various parts of our business. When we do that, we're looking at different types of margin and they tell us very different things about how business is going.

Here's a sample P&L expressed in margins:

And here it is broken down by the 4 types we'll cover today:

Think of it as peeling back layers of an onion (maybe layers of a cake would be more appetizing) — each margin (layer) gives you a look at your business.

1) First layer — product margin and gross margin

Hearing "product margin" should make you think back to the concept of mark-up vs. margin. It's a measure of pricing at the product level. If you have low product margins, you better have big volumes or very big ticket sales prices.

A close sibling is gross margin, which is sales minus all direct costs like COGS, materials, direct labor, shipping to the customer, fuel, supplies, etc. It's all costs baked into servicing, delivering, or fulfilling a sale to your customer.

Gross margin tells you how efficient your core business is at turning sales into profit. It's really hard to have a profitable overall business without healthy gross margins (and don't try to make it up on volume!). Track this one closely.

2) Next layer — operating margin

Operating margin captures all the overhead costs in running your business, things like rent, utilities, salaries, and marketing costs. After paying those, what’s left is your operating profit. Key items excluded from operating margin are interest expenses, depreciation, taxes, and other non-operating gains/losses (like sale proceeds on an old or unused truck).

At this point, our product margin told us pricing strategy, gross margin told us efficiency of core business production/delivery/service, and operating margin tells us efficiency of the entire business before adding in our ownership and financing structure.

3) Final layer — net margin (bottom line)

Finally, we get to net margin. This is the bottom line (literally).

It’s what’s left after you’ve paid for everything, including interest on loans (your capital structure), depreciation, non-operating gains/losses, and taxes (driven by ownership structure).

While I'd argue operating margin is more important when determining overall business value to a new owner, the costs between operating and net margins are real and they can eat into your profits! So pay attention to both.

Why this matters

Each margin calculation tells you the health of various parts of your business — pricing, delivery, overhead, capital structure, etc. It's possible to have healthy margins in one area and unhealthy margins in another (i.e. too much debt).

Your financial review should include common-sized financial statements which give you a quick view at your entire margin profile each month, quarter, or year. Here's a sample of what that could look like:

Your homework — With yearend financials coming together, it's a great time of year to look at your margins and compare them to 2023 and 2022. What are the trends? Do you have solid top-level margins (product/gross) but weak operating or net margins? Let this dictate where to dig deeper.