“I don’t really want my business to have higher profits,” said no entrepreneur.
For most business owners, their primary goal is to generate as much income as possible and increase the income potential of their business over time. While it is important to fully understand how much money your business is making, income values alone do not provide enough information to help you assess the health and growth potential of your small business.
To better assess the financial health of your business, you’ll want to explore your profit margin, gross margin, and net profit margin numbers. In this article, we’ll break down each of these elements, including formulas, examples, and tools you can use to calculate these percentages starting today.
What is the profit margin?
Profit margin is a profitability ratio used by businesses to measure what percentage of a business’s net income comes from sales. Because this figure also takes into account business expenses, it measures a company’s ability to manage expenses versus sales.
How to calculate the profit margin
You can use three different formulas to calculate profit margin, gross margin, and net profit margins. If you prefer to do the math automatically, try a gross profit calculator. These online tools use the same formulas we’ve outlined below, and they’re free. Here are some of our favorites:
If you want to manually calculate your profit margins, gross and net, let’s take a look at the formulas.
Pro tip: You can also follow this video from The Organic Chemistry Tutor:
Profit margin formula
To calculate the profit margin, just divide the net income by the net sales.
Let’s break down the variables of this equation further.
- Income: The total amount of money a business earns. Throughout this article, and generally in most businesses, revenue, total sales, and gross sales are used interchangeably.
- Net revenue: To find net income, subtract total expenses from total sales. (Total expenses – Gross sales)
- Net sales: Calculate net sales by subtracting total returns or refunds from total sales. (Total returns – Gross sales)
The numbers needed to calculate these values can all be found on your company’s balance sheet. Here is an example :
An entrepreneur with a boutique bakery selling specialty cookies had gross sales of $ 100,000 in one year. The company issued $ 5,000 in refunds, bringing its net sales to $ 95,000 for the year. (Total returns – Gross sales)
That same year, the company had expenses of $ 70,000 bringing net income to $ 30,000. (Total expenses – Gross sales)
With these values, here’s how we calculate the profit margin for the boutique bakery business:
Profit margin = (Net income / Net sales)
Profit margin = $ 30,000 / $ 95,000 x 100 = 31.5%
The profit margin we calculated tells us that the bakery business was able to convert 31.5% of sales into profit. In other words, for every dollar the business earned, $ 0.0315 was profit. While this is a fairly straightforward example, profit margin values and their complexity can vary depending on the business.
It is important to note that there is no unique profit margin number that separates a good profit margin from a bad profit margin. In fact, the quality of your business’s profit margin will largely depend on your industry standards.
Agricultural insurance has been one of the most profitable industries averaging over 90%. On the other hand, lawn and garden supply stores are among the lowest. When trying to assess how your business is performing based on profit margins, look at the average profit margins in your industry.
Additionally, the maturity of your business also plays a role. For new and growing businesses, costs tend to be higher, which can lead to lower profit margins compared to more established businesses.
Now that we understand the basics of calculating a business’s profit margin, let’s discuss other calculations that can help determine a small business’s profitability: gross margin and net profit margin.
What is the gross margin?
Gross profit is your business’s profit after taking into account the cost of goods sold.
Cost of goods sold includes the direct expenses related to the production and sale of your business’s product. This value does not include non-operating expenses.
Gross margin formula
To find the gross profit, subtract the cost of goods sold from the total income and divide that number by the total income.
Here’s what that equation looks like:
Now let’s apply it to an example. Suppose your business had sales of $ 2,000,000 this year. The total costs for your product were $ 650,000 for the year. Here’s how you would calculate the gross profit margin:
Gross margin = (Revenues – COGS)
Gross margin = ($ 2,000,000 – $ 650,000) / $ 2,000,000 = 67.5%
Ideally, your business’s gross profit margin should be high enough to cover your operating costs, allowing a portion of the profits to be generated. Any additional funds can be used for other expenses such as dividend payments or marketing guarantees.
This value can also help calculate the profit margin for a specific product or offering, instead of finding the margin for the business as a whole. To calculate the gross profit margin for a specific product, use the revenue from sales of the product and the costs associated with producing the product.
What is the net profit margin?
Net profit margin calculates how much of your income is in the form of profit. Instead of only accounting for the direct cost of creating and selling a product as gross profit margin, net profit margin represents all expenses.
Net profit margin formula
To calculate the net profit margin, subtract the total expenses from the income and divide that value by the income.
Here’s what the net profit margin equation looks like:
Let’s put it into practice with an example. If your business generates revenues of $ 2 million and total expenses of $ 1,500,000, you can calculate your net profit margin as follows:
Net profit margin = (Revenues – Total expenses) / Revenues
Net profit margin = ($ 2,000,000 – $ 1,500,000) / $ 2,000,000 = 25%
For many businesses, the net profit margin is expected to be lower than your gross profit margin. This is due to the addition of non-operating expenses. If you find that your net profit margin is lower than you would like, or lower than what is necessary for the health of your business, you can look for ways to reduce your costs – which is an easier variable to control than trying to dramatically increase income. in a short time.
Now that we understand what gross margin and profit margin are, let’s discuss the similarities and differences between the two.
Gross margin vs profit margin
Gross margins and profit margins provide valuable information about the financial health of a business. These values measure the current efficiency of a business in making a profit based on the goods and services sold. The difference between the two is in the factors used to determine profitability.
Gross margin shows how profitable a business is beyond what it spends to create and sell its products. Profit margin measures how much a business earns from each sale it makes.
Understanding both is important for getting a complete view of your business’ financial performance, and are useful data points in determining short and long term financial strategies.
Editor’s Note: This article was originally published in July 2020 and has been updated for completeness.
Originally posted Dec 31, 2021, 8:00 AM, updated Dec 31, 2021
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