Small businesses generally have one aim—to generate a profit. Tracking profit, along with revenue and expenses, is key to making informed financial decisions to keep the business running. Because the profit margin of your business allows you to measure its progress and can help determine its success, it’s important to understand how it’s calculated and how it can be improved.
- Profit margin refers to the percentage of profit made by a business and is calculated by dividing net income by revenue.
- There are three types of profit margin: gross profit margin, operating profit margin, and net profit margin.
- Profit margins can be improved by reducing costs or increasing the price of the products.
What Is Profit Margin?
Profit margin is a key business metric in measuring the success of your business. Calculating profit margin determines the percentage amount of profit made in comparison to your sales made, or revenue. Rather than showing a dollar amount for the profit made, profit margin shows a ratio as indicated with a percentage amount. Profit margin can help to make pricing decisions, identify any issues, and ultimately help grow your business.
This percentage shows the overall financial standing of your business, with a higher profit margin indicating success and a lower profit margin indicating that changes may be needed to cover expenses. Profit margins across different industries vary as one number may be considered a high profit margin in one industry but low in another. This can be calculated by referring to the income statement, a financial statement used by businesses to track income and expenses.
Types of Profit Margin
There are three types of profit margin used to measure different aspects of the profit of a business:
- Gross profit margin
- Operating profit margin
- Net profit margin
Gross Profit Margin
Gross profit margin is used to determine the percentage of profit gained after deducting the production costs, known as the cost of goods sold (COGS).
Gross profit margin can be beneficial when determining the profit from a specific product line. It shows the markup of specific products and can give insight when making pricing decisions.
To calculate gross profit margin from the income statement, refer to the amounts for COGS and revenue.
Operating Profit Margin
Operating profit margin is calculated based on the operational side of the business. It considers operating costs and profits made from operational activities. For example, rent, utilities, office supplies, and payroll are necessary to run everyday operations of the business, so these are considered operating costs.
To calculate the operating profit margin from the income statement, determine the amounts for the business’s gross profit, operational costs, and revenue.
Net Profit Margin
Net profit margin takes into account all other expenses of the business, such as taxes, investments, and the cost of goods sold (COGS). While gross profit margin and operating profit margin focus on particular lines of the income statement, net profit margin is considered more accurate as it covers all business expenses.
To calculate the net profit margin from the income statement, refer to the bottom line, or the total amounts at the bottom of the statement.
How To Calculate Profit Margin
On the income statement, you’ll find lines with the amounts necessary to calculate profit margin, such as revenue, gross profit, net operating income, and net income, commonly referred to as the bottom line. Depending on the type of profit margin, you’ll use one or more of these lines. The overall profit margin of a business can be calculated using the formula:
Profit Margin = Net Income ➗ Revenue
Let’s say your net sales equal $50,000 after all discounts and returns are accounted for and your business’s bottom line is equal to $10,000. The profit margin would then equal to 20%, as $10,000 (net income)/$50,000 (revenue) = 20% profit margin.
Gross Profit Margin Formula
To calculate gross profit margin, divide the amount of gross profit by the amount of sales, or revenue, so the equation would be:
First, find the gross profit amount, which is revenue minus COGS. Once you calculate this, place it into the following formula:
Gross profit margin = Gross profit (Revenue - COGS) ➗ Revenue
So for example, $5,000 (gross profit) /$50,000 (sales) = 10% gross profit margin.
Operating Profit Margin Formula
To determine profit margin before interest and taxes are considered, use the operating profit margin formula, which is:
Operating Profit Margin = Net Operating Income / Revenue
First, find the net operating income, which is earnings before interest and taxes, or EBIT. Let’s say your business accounts for $20,000 in net operating income. Using the formula, place the amounts: $10,000 (net operating income)/$50,000 (sales) = 20% operating profit margin.
Net Profit Margin Formula
To calculate this margin, refer to the net income amount after all other non-operating expenses, such as taxes, are included. Use the following formula:
Net Profit Margin = Net Income / Revenue
Again, let’s say your revenue is $50,000 and your net income, or bottom line, equals $8,000. Place these amounts in the formula: $8,000 (net income)/$50,000 (revenue) = 16% net profit margin.
Choosing Your Target Profit Margins
When deciding on target margins for your business, consider what works best for your industry. Certain target profit margin benchmarks may be reasonable to achieve for a specific type of profit margin, but not for others. For example, the mining industry has a benchmark of about 25% to 35% for gross profit margin, while farming benchmarks could start at 20% for net operating profit.
Other factors may impact target margin benchmarks, such as the industry average and the economy.
Target profit margin analysis consists of pricing your products effectively. Determining your prices will involve research and strategic decisions. Factors such as whether the product is new or focusing on production costs rather than demand can also impact the prices
How To Improve Your Profit Margins
There are several ways businesses can work to improve their profit margins. Some methods may work better depending on the business, the industry, and customer base.
- Reducing costs by cutting expenses can help to ensure that customers won’t be affected by changes in products.
- Increasing the costs of products can help increase profit margin if the demand remains the same, However, you should consider improving your product’s design or use so customers are still willing to pay the increased price
- Branding and promotional techniques may help to improve your profit margin by aiming to add value to the products, which allows customers to continue to purchase products at increased prices.
Frequently Asked Questions (FAQs)
What does negative profit margin mean?
Since profit margin refers to the amount made after expenses are considered, having a negative profit margin would suggest that the business cannot cover its expenses and therefore doesn’t generate a profit.
What businesses have the highest profit margin?
Having a high profit margin is based on how the business manages its funds and can be impacted by a variety of factors. In general, luxury brands tend to have a higher profit margin since consumers are willing to pay high prices, though businesses in different industries can turn high profit margins.