What are Profit Margins and How do you Calculate Them? (2024)

What is a profit margin?

Profit margin measures your business’s profitability. It is expressed as a percentage and tells you how much of every dollar in sales or services your company keeps from its earnings. Profit margin represents the company’s net income when it’s divided by the net sales or revenue. Net income — or net profit — is determined by subtracting the company’s expenses from its total revenue.

What are the different types of profit margins?

Profit margins have several categories, including gross, operating and net profit margins.

Gross profit margin

This is the simplest profit margin to calculate. Your gross profit margin is your overall gross revenue minus the cost of goods. It may not reflect other major expenses.

Operating profit margin

Operating profit margin accounts for operating costs, administrative costs and sales expenses. It includes amortization rates and asset depreciation but doesn’t include taxes, debts and other nonoperational or executive-level costs. It tells you how much of each dollar is left after all operating costs to run the business are considered.

The accounting formula for operating profit margin is simple to follow:

Operating income ÷ Revenue x 100 = Operating profit margin

Net profit margin

Net profit margin is the most difficult type of profit margin to track. However, it gives you the most insight into your bottom line. It takes into account all expenses and income from other sources, such as investments. Here is the simplified formula for net profit margin:

Net income ÷ Revenue x 100 = Net profit margin

Your net income can also be defined as your gross revenue minus pretty much all of your costs, including the cost of goods sold (COGS), operating expenses, interest and taxes.

How do you calculate profit margin?

Let’s start with your gross profit margin. It’s the simplest metric for determining profitability and one of the most widely used financial ratios.

Suppose your business makes $100 in revenue and it costs $10 to make your product. If you make more than one item — or offer more than one service — you can either average the costs of making each product or calculate a separate gross margin for each one.

COGS is the cost of making a product. It includes wages and raw materials but not overhead and taxes. In this example, revenue minus the cost of goods sold would be $100 – $10 = $90. Once you determine your gross profit ($90), divide that number by your revenue ($100): $90 ÷ $100 = 0.9. To get the final percentage, multiply that number by 100, which makes the profit margin 90 percent in this case.

Why is profit margin important?

Profit margin is crucial for avoiding pricing errors and cash flow challenges.

“Profit margin is important because, simply put, it shows how much of every revenue dollar is flowing to the bottom line,” explained Ken Wentworth of Wentworth Financial Partners. “It can quickly help determine pricing problems. Furthermore, pricing errors can create cash flow challenges and, therefore, threaten the ongoing existence of your entity.”

Knowing your industry is key to determining if you’re hitting the right profit margin. For example, restaurant profit margins tend to be razor thin, ranging from 3 percent to 5 percent for a healthy business. In contrast, other industries have much higher profit margins. “[In] the consulting world, margins can be 80 percent or more — oftentimes exceeding 100 to 300 percent,” Wentworth noted.

How can you improve profit margins?

Your company’s margins reflect its overall profitability relative to its gross sales. While many companies seeking fast business growth focus their efforts on improving sales, increasing profit margins is another way business owners can drastically boost profitability. By widening your profit margins, you can make more from every dollar of your gross revenue.

Here’s some advice about improving profit margins:

• Track expenses: One of the most important steps in improving your profit margins is tracking business expenses. If you don’t know what you’re spending money on, how can you cut costs and ultimately improve your profit margins?
• Cut operating and overhead costs: If your gross profit margin and operating profit margin are healthy, but your net profit margin shows issues with the bottom line, you have nonessential operating costs and overhead you can cut. If the problem shows up at the level of the operating profit margin, your operating costs are more than you can cover at the price you’re charging for your goods or services.
• Stock up when cash flow is healthy: “Buy in volume during times when cash flow is less of an issue and try to stock up during strong seasonal times,” advised Deborah Sweeney of Deluxe Corporation. “Determine what you spend vs. what can be cut out; the more detailed you can be, the better.”
• Track customer and product profit margins: Wentworth recommends tracking specific customer and product profit margins. If you have an unprofitable product or service with an exceptionally low price, consider raising its price, reducing production costs or discontinuing it.

Best accounting software for tracking profit margins

Reviewing your profit margins is straightforward when you choose the right accounting software. The best accounting software can provide real-time financial insights and give you a clear profitability picture anytime you need it. Consider the following highly regarded platforms:

• Intuit QuickBooks Online: QuickBooks makes it easy to track your expenses and profitability by providing a real-time snapshot of your cash flow. Our QuickBooks Online review explains how this platform’s automated transaction tracking can keep your finances organized.
• Xero: Xero’s user-friendly profit and loss statements show you how much income you’ve earned compared to your expenses. Our Xero accounting software review highlights this platform’s dashboard, which features a profitability overview and a schedule of upcoming expenses for pending projects.
• FreshBooks: FreshBooks provides extremely accurate expense categorization as part of its bank reconciliation suite. Read our FreshBooks accounting software review to learn about the profitability tracking by project feature in its Premium plan.

Track profit margins and know how much your business is worth

A healthy profit margin depends on your industry, but the calculation process remains the same no matter what field you’re in. It’s not just about understanding your business’s true value. Having your finger on the pulse of your profit margins is necessary for planning ahead. From budgeting for expenses to determining when you must change prices, profit margins give you the full picture.

Dock Treece contributed to this article. Source interviews were conducted for a previous version of this article.