Profit margin is the percentage of revenue (income from sales) your business keeps as profit. It is one of the most common metrics used to determine your business’s health. Using profit margin is an easy way to compare your business with others in your industry. Because profit margin is a percentage, a mom-and-pop retail shop can compare its profit margin with a big-box retailer and determine how it’s performing compared with the competition even though the competition may be operating on a much larger scale.
The four types of profit margin and what they tell you
When someone refers to profit margin, they are usually talking about the bottom line, or net profit margin. While net profit margin is important, there are three other kinds of profit margin that can also give you insights into the health of your business.
Gross profit margin
Gross profit margin tells you how much of every sale is available to use for your business operations. The formula for gross profit margin is:
(Net sales – Cost of goods sold) / Net sales = Gross profit margin
“Net sales” refers to your total revenue from sales after subtracting discounts and returns. “Cost of goods sold” refers to the expenses a business incurs to produce a product or deliver a service. When a service is delivered, “cost of sales” is often used instead of “cost of goods sold.”
An example
Let’s say your business manufactures fireworks. Your net sales for the past year total $750,000. The cost of manufacturing those fireworks is $300,000. Your gross profit margin would be calculated as follows:
($750,000 – $300,000) / $750,000 = Gross profit margin
$450,000 / $750,000 = $0.60
60% = Gross profit margin
In other words, 60 cents of every dollar your business makes in sales (after discounts and returns) is available for you to use to run your business.
Gross profit margin is often used to determine which products or services are most profitable, but you can also use it to review a business’s overall profitability before accounting for operating costs.
Operating profit margin
Operating profit margin tells you how much of your business’s income is available to pay debt, taxes and draws or distributions to the business’s owners or shareholders. The formula for operating profit margin is:
(Operating income / Revenue) x 100 = Operating profit margin
Before you can calculate your operating profit margin, you first need to calculate your operating income. And before you can calculate your operating income, you must calculate your gross profit. Gross profit is different from gross profit margin. In our example above, the gross profit for your fireworks business is $450,000, or revenue ($750,000) minus cost of goods sold ($300,000).
Revenue – Cost of goods sold = Gross profit
$750,000 – $300,000 = $450,000
$450,000 = Gross profit
Once you know your gross profit you need to subtract your operating expenses from it to get your operating income number. Let’s say your operating expenses total $175,000 per year. This is how much you pay for rent, utilities, payroll and everything except income taxes and interest. You’ll also exclude draws or distributions to the owners or shareholders of the company from your operating expenses calculation.
Gross profit – Operating expenses = Operating income
$450,000 – $175,000 = $275,000
$275,000 = Operating income
Now you have all the information you need to calculate your business’s operating profit margin.
(Operating income / Revenue) x 100 = Operating profit margin
($275,000 / $750,000) x 100 = 37%
37% = Operating profit margin
The picture so far
Let’s take a minute to step back and look at what we now know about your business:
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Your business generates $750,000 in sales.
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It costs you $300,000 to generate that $750,000. This means your business has $450,000 available for operations. This equals 60 cents of every dollar your business earns.
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$175,000 of that $450,000 is used to run your business. Remember, this amount doesn’t include interest, taxes, debt payments or draws or distributions.
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$275,000 of the $750,000 your business generates is available for non-operating payments. This equates to 37% or 37 cents of every dollar your business earns. In other words, 63 cents of every sale goes to either producing that sale or operating your business.
Pretax profit margin
Pretax profit margin is essentially the same as operating profit margin, except now you’ll include interest (both expenses and income). Operating profit margin and pretax profit margin are often used interchangeably. The distinction only becomes an issue when a company is being valued by a banker or a professional valuator for sale or acquisition. Bankers and valuators exclude interest from their valuations.
The important takeaway here is that pretax profit margin includes all income (including interest income) minus all expenses except taxes.
Net profit margin
Net profit margin is usually what people mean when they refer to profit margin. Net profit margin is the culmination of all the other types of profit margin. It looks like this:
((Operating income – Other expenses – Interest – Taxes) / Revenue) x 100 = Net profit margin
Revenue – Cost of goods sold = Gross profit
Gross profit – Operating expenses = Operating income
Let’s look at the three components of the equation we haven’t discussed yet:
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Other expenses: This refers to nonoperating expenses the business incurs. A common “other expense” is the gain or loss on the sale of an asset. For the sake of our example, let’s say we sold a label machine we no longer use because we stopped producing firecrackers. After accounting for depreciation, we lost $1,000 from the sale. That $1,000 is an “other expense.”
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Interest: Interest sometimes gets lumped in with “other expenses.” Like the gain or loss on the sale of the label machine, interest doesn’t directly relate to our business’s operations. Let’s say we earned $2,500 in interest on money held in savings accounts and spent $5,000 in interest on a loan for a new HVAC system for our plant. We would net these two amounts together and subtract the $2,500 in net interest when we complete our net profit margin equation. If we had earned $5,000 in interest and only spent $2,500, then we would add the $2,500 when we complete the net profit margin equation.
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Taxes: Unless your business is a C-corporation, taxes won’t appear on your profit and loss statement as an expense. Most businesses in the U.S. are taxed as pass-through entities, meaning individuals pay the taxes and not the business itself. However, let’s assume our fireworks business is a C-corp and paid $7,500 in taxes.
Now we’re ready to calculate our net profit margin:
(($275,000 (operating income) – $1,000 – $2,500 – $7,500) / $750,000 (revenue)) x 100 = Net profit margin
($264,000 / $750,000) x 100 = 35%
35% = Net profit margin
Boiling it all down
We now have a pretty clear picture of your business’s profitability. In summary:
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60% of every dollar in sales is available for you to use to run your business (gross profit margin).
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You have 37% of every dollar in sales available for debt payments, taxes and draws or distributions after paying operating expenses. The other 63% goes to either producing the sale or running the business (operating profit margin).
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After you pay your taxes and account for interest, 35% of your business’s sales are available for draws or distributions and debt payments (net profit margin).
What metrics are most important?
For the majority of small businesses, gross profit margin and net profit margin will be most important and most meaningful. These two metrics will let you compare your business with others in your industry so you can see at a glance how you are doing, regardless of the size of your competition.
What is a “good” profit margin?
Generally speaking, the higher your profit margin, the better. A high gross profit margin means you have more money available to run your business. A high net profit margin means you have more money available to distribute to owners or shareholders in the business.
A “good” profit margin varies from industry to industry. Some industries — like food services — have high overhead costs and by extension low profit margins. Professional services industries — like accounting and attorneys — have lower overhead costs which result in high profit margins. Overall, though, a 5% margin is low, a 10% margin is average, and a 20% margin is good or high. So try to target a net profit margin between 15% and 20% in your business.
How can you increase profit margin?
Reducing operating expenses is an easy way to quickly increase net profit margin, but in order to maximize overall profitability, businesses should also focus on increasing gross profit margin.
There are four primary ways to increase gross profit margin, which by extension increases net profit margin.
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Discontinue products or services with a low gross profit margin. The exception to this is “loss leader” products that attract new customers or encourage them to buy higher-margin products.
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Expand your product or service line carefully. Sometimes the administrative costs of managing more products or services can eat up your additional profitability.
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Reprice low-margin products or services. Referring back to our fireworks example, let’s say each unit is priced at $7.50 and you sold 100,000 units. If you increase the unit price to $8, your net sales would increase to $800,000, making your gross profit margin ratio 63%.
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Find less expensive ways to obtain or produce products or services. Let’s say you reduce your cost of goods sold by $0.50 per unit. Your cost of goods sold on 100,000 units would drop from $300,000 to $250,000, and your gross profit margin ratio on $750,000 in net sales would then be 67%.
