How to Calculate Profit Margin
Learn about the different types of profit margins and how to calculate profit margins with our helpful guide.
Running a successful business means making good profits, right? While that is true, there’s a little more to it. Your business needs good profit margins, which signify healthy company financials.
How do you know what your profit margins are, and more importantly, how do you know if they’re optimal? We’ll cover how to calculate profit margin and the different types, so you can clearly see how your company is doing.
But before we start, let’s understand why companies need to calculate profit margins. A profit margin is a percentage of your business’s revenue after accounting for operating costs, costs of goods and services, and more — or, even more, simply a brief look at how profitable your business is. While this calculation is beneficial for understanding your company’s health, it’s crucial to show potential investors.
Types of Profit Margins
Before you turn into the meme of a person with glazed eyes and swirling mathematical equations, take a minute to understand the three different types of profit margins. Each has a different profit margin formula, which we’ll cover in the next section.
Gross Profit Margin
Gross profit margin is the simplest type of measurement because it only calculates what amount remains after the cost of goods sold (COGS). Gross profit is typically only used for specific products or services, not every single product or service your business offers.
Operating Profit Margin
This stage is a bit more complex than gross profit margin, but bear with us. Operating profit margin calculates revenue after accounting for overhead, sales, administrative, and operating expenses. More on that later.
Net Profit Margin
If you’ve ever heard the term “bottom line,” it’s typically referring to a company’s net profit margin. This measurement goes beyond gross and operating profit margin calculations, including income from investments, one-time payments, taxes, and debt payments.
Essentially, net profit margin shows your business’s overall profitability from its total revenue — it’s the most accurate look at the health of your business.
How to Calculate Gross Profit Margin
First, let’s start with the basic formula for gross profit margin: [(Net sales – COGS) ÷ Net sales] x 100
Say, for example, that you sell ceramics for your business. You recently introduced a new product line of large decorative vases and want to know if they’re profitable compared to your original line of ceramic mugs.
First, calculate your COGS. It will account for the price of raw materials (clay, glaze, tools, and more) used for each vase, the costs of packaging (boxes, tissue paper, or bubble wrap), and your hourly labor rate.
Once you determine the COGS for your ceramic vases, you’ll subtract that number from your net sales of the products. Then, multiply that number by 100. There’s your gross profit margin for the vases.
How to Calculate Operating Profit Margin
The basic formula for operating profit margin is: (Operating income ÷ Revenue) x 100
Let’s use the same ceramics business example to explain how to calculate operating profit margin:
- Because you don’t have room at home for a pottery wheel or kiln, you rent studio space at a local artists’ workshop and gallery. The rent you pay each month is considered an overhead expense.
- Operating expenses include the costs of all materials you use to make your ceramics, but they can also include things like accounting fees. Learn if you need an accountant for your business.
- Perhaps you pay for a few different services, like EZ Texting, to help market your products and business to customers. These are considered sales expenses. If you hire someone to sell your ceramics at the local farmer’s market weekly, include the amount you pay them.
- Finally, administrative expenses could include office supplies, software platforms, and nonproduction costs.
Drumroll, please! To get the operating profit margin, you’ll add up all these expenses and divide that number by your business’s total revenue.
How to Calculate Net Profit Margin
The basic formula for net profit margin is:
[(Revenue – COGS – Operating expenses – Other expenses – Interest – Taxes) ÷ Revenue] x 100
The profit margin formula for net profit may seem overwhelming but hang tight. You already know how to calculate the cost of goods sold and operating expenses, so you’re almost halfway there. Now we’ll review the remaining three items for calculating net profit:
- Other expenses: These are expenses that don’t fall under operating expenses or COGS. Other expenses could be insurance, the cost to repair a production item (like a kiln or pottery wheel, in the example of the ceramics business), or the loss of an asset or a piece of equipment.
- Interest: If you’re paying any interest as part of a loan or line of credit, you’ll include that under interest expenses. Don’t worry — paying down a loan is a normal part of many small business start-up costs
- Taxes: Add up any tax expenses (like business taxes) you pay each year.
Now you can calculate the net profit margin using these items.
What Is a Good Profit Margin?
With various industries come various healthy net profit margins. What’s considered good for a restaurant may not be optimal for a small business selling ceramic dinnerware and décor.
You may be thinking, “Well, how am I supposed to know if my business is financially sound?” We get it. It can be challenging, especially when you’re starting, to know what makes a good profit margin for your unique company in its particular industry.
Here is a good rule of thumb for net profit margins:
- Around 20% profit margin or higher is great.
- Between 5% and 10% profit margin is good.
- Lower than 5% profit margin is unhealthy.
Remember that with profit margins, there is no magic number. Check out this NYU Stern School of Business analysis of net margins by sector, and see where your business falls in comparison.
How to Improve Your Profit Margins
If you’re unhappy with your gross, operating, or net profit margins after calculating each profit margin formula, there are most likely areas for improvement. You could purchase less expensive materials, find a cheaper business office or workspace, or raise prices on goods or services (imagine an asterisk next to this idea, as increasing prices should be done strategically).
However, not all profit margin improvement needs to center around reducing costs and increasing prices. Consider ramping up your marketing strategies to reach potential and current customers. EZ Texting is an affordable text marketing solution that helps companies reach and engage with mobile audiences — and reaching more people means getting more business.
Learning how to calculate profit margins for your business is just as important as knowing how to make a balance sheet or the perfect cup of coffee before your 9 a.m. meeting. Profit margin calculations are vital to understanding how your company is performing and which areas might need improvement.