As a business owner, it’s important for you to understand how to calculate your profit margin. However, it’s just as important to understand what those results really mean.
As a business owner, one of the most important things you can do is pay attention to business metrics. One of the most important metrics is profit margin.
Whether you’re a one-person operation, or employ hundreds of people, knowing how to calculate and understand profit margin will go a long way toward growing your business, no matter what stage your business is in.
We’ll explain what profit margin is, how to calculate margin, and what the results mean for your business.
Overview: What is profit margin?
Before you begin calculating profit margin, it’s helpful to understand profit.
In simple terms, profit is the amount of money a company earns after subtracting money spent to run the business. Your profit is what is left after taking revenues and then subtracting all of your expenses for a specific time frame.
Profit margin is a percentage that is based on the amount of revenue left over after some or all business-related expenses have been deducted. The higher the percentage, the more profitable your business is.
Gross profit margin vs net profit margin: What’s the difference?
Gross profit margin and net profit margin are two accounting ratios that are designed to help you measure profits against revenue, with the results indicating how profitable a business is by measuring the percentage that revenue exceeds costs.
These two profit margin ratios provide a good indicator of business health, with gross profit margin providing a good overview of business health and profitability, while net profit margin is designed to measure how much of your company’s net income is generated from revenue.
How to calculate gross profit margin
Calculating gross profit margin is simple when using the profit margin calculator. Here’s an example:
Company A sells hair care products. Recognizing revenues using the revenue recognition principle, it currently shows revenues in the amount of $50,000. The cost of the goods that it sells is $29,000. The first calculation you’ll perform is to determine gross profit:
$50,000 – $29,000 = $21,000 gross profit
Next, to determine the gross profit margin, you will divide gross profit by revenue:
$21,000 ÷ $50,000 = 0.42
Finally, you will multiply your gross profit by 100 to determine your gross profit margin percentage:
0.42 x 100 = 42% gross profit margin
This means that Company A currently has a gross profit margin of 42%.
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How to calculate net profit margin
The formula to calculate net profit margin requires more steps, as you’ll have to also subtract operating and other expenses as well as cost of goods sold. Remember, Company A has revenue in the amount of $50,000, with the cost of goods sold coming in at $29,000. But Company A also has expenses totaling $6,000. The first calculation would look like this:
$50,000 – ($29,000 + $6,000) = $15,000 net profit
The next calculation would be to divide net profit by total revenue:
$15,000 ÷ $50,000 = 0.3
The final step is to multiple net profit by 100 to calculate your net profit margin:
0.3 x 100 = 30% net profit margin
If you currently have a sales mix, meaning you sell multiple products, it can be helpful to calculate the margin mix for all of your products individually. This margin calculation can help you determine which products are the most profitable.
What does profit margin tell you about your business?
Whether you’re calculating your profit margin to complete financial projections or create a business budget, you also need to understand what those results mean. Here are just a few things that your gross profit margin or net profit margin can tell you about your business.
1. How much profit is made on each sale
Company A had a gross profit margin of 42%. This means that for every dollar that Company A generated in revenue, it made $0.42 in profit before other expenses were subtracted. Once operating and other expenses are subtracted, Company A made $0.30 for each dollar earned.
That’s why it’s helpful to calculate your profit margin separately for each product that you sell, which will allow you to see how well or how poorly each product is performing.
Whether the business is successfully converting revenue into profit
While it’s important to know how much revenue your business is earning, it’s even more important to know how much of that revenue is actually being converted into profit.
For instance, while earning $1 million in revenue is great, if your cost of goods sold is $1.1 million, you’re losing money. Likewise, if after expenses, you end up with a profit margin of 1%, any market changes, decrease in sales, or economic downturn can severely affect your business.
The overall success of your business
Prior to investing in a business, most investors will want to look at your profit margin, particularly since a low profit margin can signify issues such as stagnant sales, poor business decision-making, and higher-than-average costs associated with selling your products; all of which will raise numerous red flags for both investors and lending institutions.
FAQs
Calculating your profit margin for each of your products will enable you to gain insight into the overall success of your sales mix. If you only sell one or two products, this information may be unnecessary, but for companies that sell multiple products, knowing how each product is performing is vital to the overall success of your business.
The higher the number, the better. Remember that when calculating profit margin, the final margin total is based on how much revenue is actually being converted to profit. So if your profit margin is less than 10%, that means that you’re converting less than $0.10 for every dollar of revenue you’ve earned, leaving you vulnerable to market changes or an unplanned drop in sales.
Industry wide, a profit margin of 10% is considered average, while a good profit margin is 20% or higher.
There are many things you can do if you feel that your profit margin is too low, but here are three things that can help raise your profit margin:
- Reduce costs: By diving deeper into your expenses, you can identify and correct problem areas. For instance, if you’re incurring a lot of overtime costs, implement ways to streamline operations, such as automating tasks, or eliminating inefficiencies.
- Increase prices: While increasing prices isn’t always the best solution, take a look at your competitor's pricing to see if raising your prices may be justified.
- Work on customer retention: We’ve all seen large retailers who spend a lot of time and money offering reduced pricing and special deals to their new customers while their existing customers get nothing. Instead of spending a lot of time, effort, and money solely on attracting new customers, why not put significant effort into making your current customers happy? This can be done in numerous ways, such as special sales, lower pricing, and offering rewards to current customers.
Other options include looking for new suppliers, dropping customers who are no longer profitable, and looking for other ways to streamline services.
Profit margin says a lot about the health of your business
Calculating your profit margin can provide you with a great deal of information on the financial health of your business. Be sure to track profit margin regularly, and avoid comparing your profit margins against those of businesses that aren't in your industry.
If you’re looking for accounting software that can help you track your gross profit margin and net profit margin, be sure to check out The Ascent’s accounting software reviews.
