A profit margin measures the percentage of business revenue remaining after certain costs have been deducted. Unlike profit, which is a dollar amount, the margin measures efficiency and financial health. It tells you how effectively your business turns sales revenue into actual profit. A company can have a high profit but a low margin, indicating poor efficiency. On the other hand, a company could have a high margin, even if its dollar profit is small.
Knowing how to calculate profit margin is crucial for any small business owner. And to do it, you really only need two components: revenue and costs. There are a few different types of profit margin you can calculate to understand your business. Let’s take a closer look.
What Is Gross Profit Margin?
Gross profit margin (GPM) is the first level of profitability analysis. It focuses exclusively on the costs directly tied to producing or acquiring the goods you sell or services you provide. To calculate it, you deduct only the Costs of Goods Sold (COGS), which includes:
Direct production materials
Direct labor
Manufacturing overhead
The formula to calculate gross profit margin is (Revenue – Cost of Goods Sold) / Revenue x 100%. For example, say a bakery sells 1,000 loaves of bread for $5 each.
Metric
Amount
Revenue
$5000 (1,000 loaves x $5.00)
COGS
$1,500 (Flour, yeast, direct labor, oven electricity)
This means 70 cents of every dollar in revenue is left over to cover operational costs and taxes. That’s a strong GPM. A lower one might indicate there’s poor cost control in the supply chain or it’s time to raise prices.
What Is Operating Profit Margin?
Operating profit margin (OPM) is often considered the best gauge of the management team’s overall efficiency because it measures profitability from the core business activities. OPM measures the profit remaining after deducting all normal costs of business, including COGS and operating expenses like overhead. These additional costs may include:
Salaries for administrative staff
Rent for office space
Marketing and advertising costs
Research and development
The formula to calculate it is (Operating Income / Revenue) x 100. (Operating income is gross profit minus operating expenses.)
Using the bakery from the first example, let’s add the operational costs:
The 30% OPM means that after covering the direct cost of making the bread and all the administrative and sales overhead, the business retains 30 cents of every revenue dollar.
What Is Net Profit Margin?
Finally, net profit margin (NPM) is the most comprehensive profitability metric, representing the money that actually goes into the owner’s equity or is distributed to shareholders. NPM measures the percentage of revenue remaining after all expenses have been deducted, including COGS, operating costs, debt interest payments, and taxes.
To calculate it, you first must determine your operating income and then subtract non-operating costs like interest expenses and taxes. Then, the formula is (Net Income / Revenue) x 100.
Continuing with the bakery’s figures, let’s include the final costs:
The Net Profit Margin of 22% is the company’s true bottom line. It shows that for every dollar of revenue, the business retains 22 cents. This is the figure most commonly used by investors and owners to assess overall success.
How to Analyze and Use Profit Margins
Like any bit of business data or information, profit margins are only as good as how you use them. They can reveal important information about your business that can guide decision-making in each of the following areas:
Benchmarking: Calculating margins can help you compare metrics over time to gauge your internal growth and efficiency. You can also compare your margins against industry averages to understand how you stack up against the competition.
Pricing decisions: Your GPM sets the absolute floor for your product’s price. If your GPM is near zero, your profit margin is too low and the business is unsustainable.
Cost control: Low profit margins signal a need to tighten budgets elsewhere to increase efficiency.
Investment decisions: Investors primarily look at net profit margin to gauge the potential return on their investment and the long-term viability of the business.
Understanding how to properly analyze profit margin can make a big difference in how you run your business.
FAQs
There’s no universal “good” margin because every industry is different. You should always benchmark your own profit margins against your specific industry.
A negative profit margin at any level means your costs exceed your revenues for that specific calculation. Basically, you’re selling your products at a loss, which is very unsustainable. A negative GPM means you’re selling for less than the cost to produce. A negative NPM means the whole company is losing money.
Ideally, you should review your profit margins monthly to identify trends quickly. At a minimum, you should take a look at them quarterly against your formal financial statements.
Table of content
Share
