How do you know if your business is profitable? One indicator is your profit margin. This measure of profitability considers your gross, operating or net profit as a percentage of revenues. But how do you calculate these ratios?
To demonstrate, we explain how to calculate profit margin.
What is the margin of profit?
The profit margin expresses how much of every dollar of sales a company keeps in its earnings. At the same time, it takes into account the costs of serving customers to find the actual profit.
A formula for calculating profit margin
There are three types of profit margins: gross, operating and net. You can calculate all three by dividing the profit (revenue minus costs) by the revenue. Multiplying this figure by 100 gives you your profit margin percentage. In each case, you calculate each profit margin using a different measure of profit.
Gross profit margin
Gross profit margin is an indicator of profits relative to production costs. Thereupon, calculate your profit margin based on gross profit. Gross profit represents your total revenue minus the cost of goods sold. As a result, this figure covers the cost of producing merchandise and can range from materials to labor.
For instance, say you pay $8,000 for goods and sell them for $10,000. Your gross profit is $2,000. Divide this figure by the total revenue to get your gross profit margin: 0.2. Multiply this figure by 100 to get your gross profit margin percentage: 20 percent.
Revenue from selling goods – Cost of Goods = Gross Profit Margin.
Operating profit margin
Overly high operating costs can impact your operating profit margin. Therefore, your operating profit is your total revenue minus your business expenses.
Your business expenses include:
- Costs of goods sold
- Operating expenses
- Administrative expenses
- Other day-to-day expenses of running a business
Let’s factor operating costs into the previous scenario to calculate the operating profit margin. Further, let’s say you paid an extra $500 in operating expenses on top of the costs of goods.
Deduct $8,500 from your total revenue, and you get an operating profit of $1,500. Next, divide this by your total revenue to get your operating profit margin: 0.15. Then multiply this figure by 100 to find the operating profit margin percentage of 15 percent.
Net profit margin
How well does your business turn revenues into profit? Look at your net profit margin. This assessment is an indicator of overall profitability calculated based on net profit.
Net profit factors in more deductions from revenue than either gross or operating profit. To sum up, it equals total revenue minus the cost of goods sold, operating expenses, interest, taxes, preferred stock, and debt repayments.
Say your total revenue is $10,000, but you paid $8,000 for goods, $500 in operating expenses and another $500 in interest payments. Now your net profit in this scenario amounts to $1,000. Divide this figure by the total revenue, and you get your net profit margin: 0.10. Next, multiply this figure by 100 to get your net profit margin percentage: ten percent.
As you can see, the ratio of profit to revenue can vary depending on the type of profit chosen for the profit margin calculation. No profit margin alone can provide a complete picture of the financial health of your business. But learning how to calculate profit margin can show you where to adjust your business strategy.
Profit vs. revenue
In finance, accounting, economics and law, profit and revenue are defined in different terms. Essentially, profit refers to the amount remaining after reckoning for all the expenses and overhead taken out in a specific period. Revenue refers to the total amount earned by a company without subtracting the cost for goods sold or expense of services provided within a particular time frame.
Revenue is income obtained by a company based on its business activities. Any type of income earned from business operations is considered revenue. Revenue is also considered an increase in assets or decrease in liabilities caused by the offering of services or products to customers.
It is commonly calculated using the following general formula:
Number of units sold x Unit price = Revenue
Similar to income, there exist different types.
- Sales revenue means earnings realized from selling goods
- Tax revenue is income the government obtains from taxes paid by the taxpayers
- Gross receipts are the annual revenues of non-profit organizations