9 Min. Read
June 5, 2024
Profit margin is an essential metric for assessing the income and health of a business. It tells business owners how much they take home after all their expenses and offers investors and shareholders a clear picture of the company’s success.
Profit margins are also important for tracking growth and improving income. Changes in profit margin can suggest helpful methods for increasing sales or decreasing operating expenses.
In this article, we’ll explore what profit margin is, different types of profit margins, and how to calculate profit margins. We’ll also look at strategies for increasing profit margin so you can find effective ways to grow your small business.
Key Takeaways
- Profit margin measures a company’s income after costs have been deducted.
- Three types of profit margins are gross profits, operating profits, and net profits.
- Net profit margin is the most common and most comprehensive measurement.
- You can increase profit margin by increasing sales or decreasing expenses.
Table of Contents
- What Is Profit Margin?
- Types and Formula for Profit Margin Calculation
- Examples of How to Calculate Profit Margin
- How Do I Increase Profit Margins?
- Conclusion
- Frequently Asked Questions
What Is Profit Margin?
Profit margin is the total amount of revenue that a company keeps after they subtract all other expenses. It’s a common way to measure how much money the company makes and is often associated with growth potential.
Profit margin is usually expressed as a percentage—for example, a 15% profit margin means that for every $1 your company brings in, you retain $0.15 as net revenue.
The most common type of profit margin calculator is net profit margin. This accounts for a company’s costs, including labor and taxes. Net profit margin offers a comprehensive way to compare your company’s sales to the total amount you keep as profit.
Types and Formula for Profit Margin Calculation
There are three main types of profit margins that businesses use to assess their success:
Gross Profit Margin
Gross profit margin is the most straightforward profit margin formula. It measures a company’s revenue after subtracting the cost of goods sold. This enables businesses to assess the basic relationship between their profits and the cost of one input.
Gross profit margin may be helpful for businesses that are significantly impacted by materials costs. It also allows a company to compare its profits to similar businesses that sell the same product. They can then use this information to assess their efficiency and consider things like suppliers and marketing which may impact their gross profit margin.
The formula for gross profit margin is:
Gross Profit Margin = (Net Sales – Cost of Goods Sold) / Net Sales
Gross profit margin is expressed as a percentage. Net sales refer to gross revenue after accounting for any returns, discounts, and other transactions that impact actual sales. To learn more about net sales, follow our guide on How to Calculate Net Sales, which explains what it is and how it’s calculated.
Operating Profit Margin
Operating profit margins can be considered the next level past the gross margin formula—it accounts for direct inputs like wages and cost of goods but does not include taxes or interest. To calculate operating profit margin, companies subtract the cost of inputs from total sales.
Operating profit margin can be a helpful indicator of the efficiency of your business. It accounts for all the day-to-day costs of running your business, including wages and administrative costs. By comparing your gross profit margin and operating profit margin, you can analyze how your day-to-day costs impact your profits.
The formula for operating profit margin is:
Operating Earnings = (Revenue – (Cost of Goods Sold + Wages + Administrative and General Costs)
Operating Margin = Operating Earnings / Revenue
Net Profit Margin
Net profit margin is the final revenue total after subtracting all costs. This includes wages, cost of goods sold, general and administrative costs, taxes, interest, and dividends paid to shareholders.
Net profit margin is often called ‘the bottom line’ because it’s the final measurement after all expenditures. A positive net profit margin means your company is turning a profit; a negative net profit number means your costs exceed your revenues.
Calculating net profit margin is key to measuring the overall health of your business. Higher net profit margins mean your company is generating more profit per dollar of revenue.
The formula for net profit margin is:
Net Profit Margin = (Operating Earnings – (Taxes + Interest + Dividends)) / Revenue
Examples of How To Calculate Profit Margin
We’ll use an example to show how to calculate the gross margin, operating margin, and net profit margin for the same company.
Gross Profit Margin Example
Company A produces lawnmowers and generates $50,000 in net sales in a month. Its cost of goods sold was $20,000.
Gross Profit Margin = (Net Sales – Cost of Goods Sold) / Net Sales
Gross profit margin = (50,000 – 20,000) / 50,000
Gross profit margin = 0.60
Company A has a gross profit margin of 60%.
Operating Profit Margin Example
To calculate the operating profit margin, we also include employee wages and administrative and general costs. This company paid its employees $5,000 in wages and had an additional $5,000 in administrative and general costs.
Operating Earnings = (Revenue – (Cost of Goods Sold + Wages + Administrative and General Costs)
Operating earnings = (50,000 – (20,000 + 5,000 + 5,000)
Operating earnings = 20,000
Operating margin = operating earnings / revenue
Operating margin = 0.4
Company A has an operating profit margin of 40%.
Net Profit Margin Example
With operating earnings of $20,000, we now include taxes, interest, and shareholder dividends. They paid $6,000 in taxes, $500 in interest, and $800 in shareholder dividends.
Net Profit Margin = (Operating Earnings – (Taxes + Interest + Dividends)) / Revenue
Net profit margin = (20,000 – (6,000 + 500 + 800)) / 50,000
Net profit margin = 0.254
Company A has a net profit margin of 25.4%.
How Do I Increase Profit Margins?
Achieving a higher profit margin is a common goal for businesses that want to expand and boost their income. There are two main ways to increase your profit margins: increasing your revenues or decreasing your expenses. We’ll look at different strategies businesses can use to address these factors.
Improve Your Marketing
Marketing can be an effective way to increase your client base to your total sales volume and boost revenue. However, it’s important to balance marketing costs against potential gains. Review your existing marketing strategy to see which elements generate leads and which drain your funds without delivering a large return.
Reassess Your Pricing Strategy
Pricing is key to revenue, but it can be difficult to find the perfect price. Pricing too high may lead to a decline in sales numbers, whereas pricing too low may result in a profit decrease even with a higher sales volume. Consider exploring competitor prices to see how you compare in the market. If you can’t match competitor prices, see whether you can compete by offering stronger service or better branding.
Analyze Product Performance
If your company offers a range of products, assess which ones generate the highest profit. This may not always be your best-selling product—instead, it’s the product with the best profit margin. Compare your sales to input prices to see which product brings in the greatest profit. You can also reach out to customers and perform customer satisfaction surveys to see if there’s anything you can improve about your products.
Streamline Operating Costs
If you discover you’re spending a lot on administrative and general costs, gather your team and brainstorm where you can boost efficiency. There may be a more affordable software product than your current one or you may be able to automate a part of your process. Improving efficiency can reduce the amount that you subtract from your total revenue.
Explore Your Tax Deductions
Many tax deductions for small business owners can reduce your total taxable income. Make sure you’re claiming all your deductions to minimize your tax bill and decrease the amount subtracted from your business revenue.
Conclusion
Profit margins are an important way to measure business health and track growth. You can use gross profits, operating profits, and net profit margin to assess different aspects of business profitability.
The right accounting system can help you track income and expenses and calculate profit margins. FreshBooks accounting software makes it easy to organize your sales and costs, track your expenses, and manage deductions. Try FreshBooks free to start streamlining your profit margin calculations.
FAQs About Calculating Profit Margin
Learn more about assessing profitability, profit margins for new businesses, and how to calculate profit margins with frequently asked questions.
How do you assess a company’s profitability?
Net profit margin is an effective way to assess a company’s profitability. It allows you to compare revenue and expenses and enables you to measure changes in productivity over time. However, net profit is not the sole indicator of a company’s profitability. Various other measures, such as profit per client and upcoming prospects, should also be considered when determining a company’s financial success. For a comprehensive understanding of these factors, you can check out our post on how to know if a company is profitable, where we have explained all of this in detail. It’s also important for demonstrating profitability to investors and shareholders.
What is a good profit margin for a new business?
Profit margins are industry-specific, so there’s no single desired profit margin percentage that’s good for all businesses. However, new businesses with a profit margin ranging from 7% to 10% are generally considered healthy. This profit margin should increase as the business grows.
How do you calculate the profit margin for a product?
You can calculate the gross profit margin for a product by subtracting the cost of goods sold from the net sales, and then dividing that by net sales. This will tell you the basic profit after subtracting the primary input price.
How do you calculate profit margin per unit?
You can find the profit margin per unit by subtracting the cost of the goods sold from the sale price. This will tell you a simple profit measurement in whole numbers. You can divide this by the sale price, then multiply by 100 to get the profit margin per unit as a percentage.
Kristen Slavin, CPA
About the author
1000more rows at the bottom Kristen Slavin is a CPA with 16 years of experience, specializing in accounting, bookkeeping, and tax services for small businesses. A member of the CPA Association of BC, she also holds a Master’s Degree in Business Administration from Simon Fraser University. In her spare time, Kristen enjoys camping, hiking, and road tripping with her husband and two children. In 2022 Kristen founded K10 Accounting. The firm offers bookkeeping and accounting services for business and personal needs, as well as ERP consulting and audit assistance.
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