Profit Margin: Types, Calculation

The 3 Types of Profit Margin and What They Tell You

profit margin being explained to young businessman
To run a successful business, you need to understand the three types of profit margins. Photo: Hero Images/Getty Images

Definition: The profit margin is a ratio of a company's profit divided by its revenue. It's always expressed as a percentage. It quickly tells you how efficiently a company is using its income. That's because a higher ratio means the company generates more profit for every dollar of revenue. A low percentage figure means its costs are so high that each dollar of income generates less profits.

The profit margin also allows you to compare the success of large companies vs small ones.

You might think a large company is doing well just because it has billions in revenue, and therefore billions in profit. However, if its profit margin is low, it might not be doing as well as a much smaller company that has a better ratio.

It also allows you to compare your company against your competitors, against your industry standard and against yourself over time.

How to Calculate Profit Margin

The profit margin formula simply takes the formula for profit and divides it by the revenue. Here's more on Profit and How to Calculate It

The profit margin formula is:

π / R

  • Where π (the symbol pi is commonly used for profit) = R - C
  • R (Revenue) = Price * X (number of units)
  • C (Costs) = F+V*X
  • Where F = Fixed cost (such as cost for a building)
  • and V = Variable cost (such as the cost to produce each product) 
  • and X= number of units.

The Types of Profit Margin

There are three types of profit margin.  The differ by what they include in Costs.

They tell managers different things about the business.

Gross Profit Margin compares revenue to variable costs. It tells you how much profit each type of product creates, without taking into account fixed costs.  These variable costs are the same as the Cost of Goods Sold (COGS). It is used within a company to compare product lines, such as auto models.

 It's not used in service companies, such as law firms, that have no COGS. 

The gross profit margin formula is:

π / R

  • Where π (the symbol pi is commonly used for profit) = R - C
  • R (Revenue) = Price * X (number of units)
  • C (Costs) = V*X
  • Where V = Variable cost (such as the cost to produce each product) 
  • and X= number of units.

Operating Profit Margin (margin ratio) includes both variable and fixed costs. It doesn't include certain financial costs. It is somewhat useful for a business because it does include all operating costs and overhead, such as personnel costs and administration, along with variable costs, or COGS. However, it is sometimes misleading because companies DO pay taxes, etc.  

The operating profit margin formula is:

π / R

  • Where π (the symbol pi is commonly used for profit) = R - C
  • R (Revenue) = Price * X (number of units)
  • C (Costs) = F+ V*X
  • F = Fixed costs to operate the business. It does not include financial costs, such as interest on debt,taken out to purchase a building etc. 
  • Where V = Variable cost (such as the cost to produce each product). It also does not include financial costs needed to produce each unit.
  • and X= number of units. (Source: Calculate Operating Profit Margin, Houston Chronicle)

    Net Profit Margin is net profit divided by net revenue.  The net profit is after every single expense is subtracted, including taxes, interest expenses, and depreciation.  These are interest payments on the company's debt, any taxes, and the depreciation or amortization of capital goods. This is typically known as EBITA, which stands for Earnings Before Interest, Tax, Depreciation and Amortization.Net revenue is minus all returns and allowances.  It's used similarly to the Profit Margin Ratio, except for one important difference. It's NOT good for comparing companies in different industries. That's because they have widely different costs. 

    π / R

    • Where π (the symbol pi is commonly used for profit) = R - C
    • R (Revenue) = Price * X (number of units)
    • C (Costs) = F+ V*X
    • F = Fixed costs to operate the business. It does include financial costs, such as interest on debt,taken out to purchase a building etc. 
    • Where V = Variable cost (such as the cost to produce each product). It also includes financial costs needed to produce each unit.
    • and X= number of units. (Source: Net Profit Margin, Finance Formulas)