Profit margin is one of the most commonly used profitability ratios, which is a basic measure of how much money a business, service, or product makes. Expressed as a percentage, profit margin is essentially how much money a company makes per transaction. In general, the higher the profit margin, the more profitable the business. Thus, this metric is often used by investors as an indicator of how successful a business is.
Calculating Profit Margin
Although there are different types of profit margins, the equation generally looks at two key metrics: business sales and business expenses. In general, profit margin can be calculated by taking business sales and subtracting your business expenses. This metric can be calculated for any period of time for specific product lines, but the metric will vary more with shorter time periods.
Types of Profit Margin
There are three types of profit margins: gross profit margin, net profit margin, and operating profit margin. Each of the following sections will dive deeper into the specific details and formulas for each profit margin type.
Gross Profit Margin
Gross profit margin defines profit as all income remaining after accounting for the cost of goods sold (COGS). COGS are expenses related to the production or manufacturing of items for sale, such as wages, raw materials, and other attributable expenses. Debt, taxes, operating or overhead costs, and one-time expenditures such as equipment purchases are excluded for COGS.
Gross profit margin compares gross profit to total revenue, reflecting the percentage of each revenue dollar that is retained as profit after paying for the cost of production.
If a company takes in a revenue of $10,000 and the cost of goods sold is $4,000, the gross profit margin would be 60%.
Net Profit Margin
Net profit margin calculates the percentage of profit a company produces from its total revenue. This percentage measures how much profit a company makes per dollar of revenue generated by dividing net income by revenue. Net income is the total amount of revenue left over after subtracting all expenses and income streams, which includes COGS, operational expenses, debts, taxes, one time payments, investments, and secondary operations.
Net Profit Margin Formula:
Net profit margin = (Net income / Revenue) * 100
If a company has a net income of $5,000 and takes in a revenue of $15,000, the net profit margin would be 33.33%
Operating Profit Margin
Operating profit margin, also known as operating income margin, EBIT margin, and return on sales, includes all overhead, operating, administrative, and sales expenses necessary to run a business. It excludes debts, taxes, and other non-operational expenses in its calculation. In other words, operating profit margin looks at all costs required to run a business day to day to illustrate the percentage of each dollar that remains after payment of all necessary expenses.
Operating Profit Margin Formula:
Operating profit margin = (Operating income / Revenue) * 100
If a company has an operating income of $10,000 and takes in a revenue of 100,000, the operating profit margin is 10%.
Why Profit Margin is Important
All profit margin variations provide useful metrics for assessing growth potential, investment viability, and how financially stable a company is relative to its competitors. That said, if there is one specific metric to focus on net profit margin is the most indicative measure of a company’s overall profitability. Maintaining healthy margins will help to ensure your business’s financial success, in turn improving your ability to qualify for a small business loan.
The Bigger Picture of High or Low-Profit Margin
Because profit margin calculations look at different business activities and isolated moments in time, you need proper context as you analyze the metrics. For example, a wedding photographer’s profit margin may fluctuate wildly from month to month as their business is seasonal, services fluctuate from client to client, and they may need to buy new equipment from time to time. General stores on the other hand, which typically have set prices and a more consistent flow of inventory and sales, will typically exhibit more consistent margins from month to month.
Thus, a wedding photographer may be better off looking at previous projects and assessing the profitability as they negotiate with new prospects. Alternatively, general stores may find more value in understanding the profit margins for specific product categories in order to optimize their inventory.
Overall, the profit margin can tell a lot about a business and is an important indicator of profitability. However, keep in mind that profit margins vary between industries and seasons, and the numbers used in the analysis need to be applied with a specific context in mind.