Profit Margin: The 4 Types, Formula and Definition (2024)

What is Profit Margin?

The Profit Margin that a business generates is one of the most important elements that inform decision-making by owners, investors, and finance teams.

However, there is no single profit margin calculation that can provide an indication of a company’s business health and financial performance. In this article, we'll explore the four profit margin formulas and how they give visibility over your company’s profitability, what ‘good’ looks like and some tips on how to increase your profit margin if you business operates across borders.

Four types of profit margin

There are four types of profit margin that can be calculated:

• Gross Profit Margin
• Operating Profit Margin
• Pre-Tax Profit Margin
• Net Profit Margin

These calculations should be used in conjunction with each other to assess the health of a business, or to benchmark it to next to other businesses. Let’s get started!

🔢 How to calculate profit margin?

To illustrate how to calculate Profit Margin, we will use an example. A business with the following assumptions:

• Revenue = £1,000,000
• Cost of Goods Sold (COGS) = £300,000
• Workers’ payroll = £200,000
• Rent = £100,000
• Depreciation = £50,000
• Marketing = £5,000
• Interest = £20,000
• Tax Rate = 30%
• One-time gain of £40,000 on the sale of a piece of land recorded during the year

Calculating Gross Profit Margin

In the income statement (also called a Statement of Profit & Loss), the Gross Profit Margin is the first profit metric line item. To put it simply, it’s a metric that shows how much profit a business makes after the direct costs of producing and getting its products and services ready for sale. If you’re in a goods/product-based business these production costs are called Cost of Goods Sold (COGS for short).

The Gross Profit Margin expresses the gross profit as a percentage of revenues, and provides an indication of what percentage of each pound or dollar of revenue generated is used to create the goods or services being provided.

The formula for Gross Profit is as follows:

The Gross Profit Margin is then calculated as:

🔢 Calculating Operating Profit Margin

The operating profit margin takes the gross profit, and deducts all the other regular expenses that a business incurs while operating (except for interest and tax).

These are called operating expenses. In addition, operating profit also includes items such as a one-time gain or loss on a sale of an asset, profits earned from minority investments, legal damages paid, etc. In short, all income and expenses that a business has to pay outside of interest and tax are encompassed within the Operating Profit Margin calculation. That is also why operating profit is often called Earnings Before Interest and Tax (EBIT).

The good news is that we can use the work from the Gross Profit Margin calculations, and just add a step to it. In the business above, payroll, rent, depreciation and marketing are operating expenses.

The formula for calculating operating profit is as follows:

The Operating Profit Margin is then calculated as:

🔢 Calculating Pre-Tax Profit Margin

Moving further down the income statement, the next Profit Margin calculation is that of the Pre-Tax Profit Margin which shows you how much profit your business is making minus all expenses except tax. This is useful in evaluating the performance and efficiency of businesses that operating across different jurisdictions with differing corporate tax rates. The pre-tax profit is also referred to as the Profit Before Tax (PBT).

Once again, we can use the work that we have done so far on the Operating Profit Margin calculations, and simply deduct interest costs from it to get to the Pre-Tax Profit Margin.

The formula for Pre-Tax Profit is as follows:

Pre-Tax Profit Margin is then calculated as:

🔢 Calculating Net Profit Margin

The last profit margin calculation is net Profit Margin; also known as 'the bottom line' as it appears at the very end of the income statement. The net profit shows you how the business is performing after all expenses have been deducted (including tax) and Ancillary Income streams have been accounted for. Put simply, the net profit margin calculation essentially displays how much of each pound or dollar of revenue generated is turned into a profit.

The formula for Net Profit is as follows:

Net Profit Margin is then calculated as

👍 What is a good profit margin?

Understanding what constitutes a 'good' profit margin is heavily dependent on several factors including the type of industry your business is in and how mature it is (to name a few). As an example, if you're a sole trader and your business is in consulting or coaching, you're likely to have far fewer overheads than a business that manufacturers bike parts and needs to pay for logistics, equipment maintenance and raw materials.

The most important thing to bear in mind is that you're comparing your performance like for like with other businesses in your sector.

Additionally, as discussed above, these profit margin calculations should be used in conjunction with each other to get the full picture of business performance.

While the Net Profit Margin seems like it covers all income and expenses generated to give the user an idea of overall profitability, it is not as useful when viewed in isolation. The Pre-Tax Profit Margin provides a better insight into the profitability of the business without taxes (which can fluctuate between different tax jurisdictions, or even between different years in the same jurisdiction).

Further up the income statement, the Operating Profit Margin is a good indicator of a company’s ability to convert its revenues into profit without accounting for interest and tax costs. This is useful because taxes paid can differ between businesses that operate in different jurisdictions.

Similarly, the financing decisions that a business makes (proportion of debt vs. equity) can impact overall P&L(Profit and Loss). A business that uses both equity and debt would have higher expenses through interest costs than a business that funds itself using only equity.

Lastly, the Gross Profit Margin offers a view of production costs as a component of overall revenue, i.e., how much it costs to produce a good or service, and get it ready for sale. The higher your Gross Profit Margin, the faster you can achieve break-even on your units sold.

As a business owner and/or decision-maker, exploring the differences between these four profitability margins is a great starting point for understanding and optimizing the costs that may be weighing down your business’s P&L.

🌎 Tips on how to increase your Profit Margin when you operate internationally

Running a business that has an international footprint comes with several potential complexities from a financial standpoint. There are likely more partners involved at each step which may reduce margins from the time that you operate your business from the same country.

While these partners have local knowledge that may be critical to the success of your business in international territories, there are certain best practices that can be followed to preserve your Profit Margin as you expand globally.

👇 Reduce operating costs

If your business is in dropshipping or e-commerce, consider whether your distribution and logistics partner is the most cost-effective one available to you. Transport and warehousing costs can often be significant when factored into Cost of Goods Sold. Consider working with a Third-party Logistics (3PL) service provider - they often work with carriers for lots of different businesses which typically brings rates down

💷 Use a multi-currency account to reduce foreign exchange costs

If your business sells or operates in different countries and relies on using multiple currencies, you will likely incur FX costs in switching from one currency to another. By partnering with a payment provider such as Wise, these costs can be eliminated to a large degree, thus saving you added costs on your international purchases. You can get paid like a local - get account details and receive payments in 10 different currencies for free!

📦 Look at how to better manage your inventory

Having insights on your product levels and which ones are making your business the most money is a key to improving your bottom line. Using specialist order management software can help you monitor and optimize inventory levels to make sure there’s not too much or too little stock.

This has an added advantage of improving your cash flow as until your products are sold, they are effectively costing you money. There are also probably some products that don’t do well at all - the money you front for these could be used to develop or make more of your best performing lines.

🚚 Renegotiate or find new supplier contracts

If your business has grown quite fast and there’s much more demand for your product, you might be able to revisit your contracts. Bigger overall orders could mean there’s room to push for a discount. If you’ve been working with a more expensive supplier you might find new partners in different countries who can offer you a better pricing structure.

💡💵 Save time and money with Wise for Business

Whether your business works with freelancers in different countries or you're working with suppliers in multiple currencies, reviewing your overseas payments can be one of the most impactful ways to reduce your costs and improve your profit margin.

International payments are often overlooked by businesses, but these transactions could be weighing on your operating costs if you’re not using the right banking solution.

Here’s an example:

Traditional banks typically charge 2% - 3% on FX mark-up when you convert between currencies. On top of that, there’s a Swift fee of £20 - £60 per transfer. When these add up, international payments become expensive. That’s £300 for every £10,000 pounds sent. On top of that, the receiving bank also takes a cut when your recipient receives the money.

But here’s the good news. There is a solution!

Wise for Business is designed to reduce payment costs for SMEs on international payments. Which is why:

1. There’s no FX mark-up
2. Conversion fees are only 0.65% on average (0.35% on major currencies like GBP, USD and EUR)
3. Offer a quick to open multi-currency account to help you receive international payments and manage currencies in one account!
4. You can have better FX hedging using the multi-currency account - better visibility of your funds in different currencies all in one account.

Check out Wise Price Page to see how much you could save.

Sources:

1. HSBC international transfer calculator

• Wise blog - HSBC fees research
• Wise blog - Comparison with other providers
• Wise blog - Natwest fees research
• Wise comparison page