"I don’t really want my business to have higher profits," said no entrepreneur ever.
For most business owners, their main objective is to bring in as much revenue as possible and to increase the earning potential of their business over time. While having a solid understanding of how much money your company is bringing in is important, revenue values alone don’t provide enough information to help you gauge 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 each of these down, including formulas, examples, and tools you can use to calculate these percentages starting today.
What is profit margin?
Profit margin is a profitability ratio used by businesses to measure what percentage of a company’s net income comes from sales. Because this figure also factors in business expenses, it measures how well a company is able to manage expenses relative to sales.
How To Calculate Profit Margin
You can use three different formulas to calculate the profit margin, gross margin, and net profit margins. If you'd rather 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 a few of our favorites:
If you want to calculate your profit, gross, and net profit margins manually, let's take a look at the formulas.
Pro Tip: You can also follow along with this video by The organic Chemistry Tutor:
Profit Margin Formula
To calculate profit margin, simply divide net income by net sales.
Let’s break down the variables of this equation further.
Revenue: The total amount of money that a business earns. Throughout this post, and typically in most businesses, revenue, total sales, and gross sales are used interchangeably.
Net income: 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’s an example:
An entrepreneur with a boutique baking business selling specialty cookies made $100,000 in gross sales in one year. The company issued $5,000 in refunds, bringing its net sales to $95,000 for the year. (Total Returns - Gross Sales)
This same year, the company had $70,000 in expenses bringing net income to $30,000. (Total Expenses - Gross Sales)
With these values, here is how we calculate the profit margin for the boutique baking company:
Profit Margin = (Net Income / Net Sales)
Profit Margin = $30,000 / $95,000 x 100 = 31.5%
The profit margin we calculated tells us the boutique baking business was able to convert 31.5% of sales into profit. In other words, for every $1 the business made, $.0315 of it was profit. While this is a fairly straightforward example, profit margin values and their complexity can vary depending on the company.
It is important to note that there is no single profit margin number that separates a good profit margin from a bad profit margin. In fact, how good your company’s profit margin is will largely depend on the standards in your industry.
Additionally, the maturity of your business also plays a role. For new and scaling companies, costs tend to be higher which can lead to lower profit margins compared to more established companies.
Now that we understand the basics of calculating a company’s profit margin, let’s discuss the other calculations that may help determine the profitability of a small business: gross margin and net profit margin.
What is gross margin?
Gross margin represents how much profit your company has after accounting for the cost of goods sold.
Cost of goods sold includes direct expenses related to the production and sale of your company’s product. This value does not include non-operating expenses.
Gross Margin Formula
To find the gross margin, subtract the cost of goods sold from total revenue and divide this figure by total revenue.
Here’s what that equation looks like:
Now let’s apply it to an example. Say your company earned $2,000,000 in revenue this year. The total costs related to your product were $650,000 for the year. Here’s how you would calculate gross profit margin:
Ideally, your company’s gross profit margin should be high enough to cover your operating costs allowing some profit to be leftover. Any additional funds can be used for other expenses such as dividend payments or marketing collateral.
This value can also help calculate the profit margin of a specific product or offering, instead of finding the margin for the company as a whole. To calculate the gross profit margin of a specific product, use the revenue earned from sales of the product, and the costs related to the production of the product.
What is net profit margin?
Net profit margin calculates how much of your revenue is profit. Instead of accounting for just the direct cost of creating and selling a product like gross profit margin, net profit margin accounts for all expenses.
Net Profit Margin Formula
To calculate net profit margin, subtract total expenses from revenue, and divide that value by revenue.
Here’s how the equation for net profit margin looks:
Let’s put it into use with an example. If your business earns $2 million in revenue and has $1,500,000 in total expenses, you can calculate your net profit margin as:
Net Profit Margin = (Revenue - Total Expenses) / Revenue
For many businesses, it is expected to have a net profit margin that is lower than your gross profit margin. This is due to the addition of non-operating expenses. If you find your net profit margin is lower than you would like, or lower than what is needed 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 drastically increase revenue in a short amount of 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
Both gross and profit margins provide valuable insight into the financial health of a business. These values measure how effective a company currently is at earning a profit based on the goods and services sold. The difference between the two involves the factors used to determine profitability.
Gross margin shows how profitable a company is above and beyond how much they spend to create and sell their products. Profit margin measures how much a company earns from each sale they make.
Understanding both is important for getting a well-rounded view of the financial performance of your company, and are useful data points for determining both short and long-term financial strategies.
Editor's note: This post was originally published in July 2020 and has been updated for comprehensiveness.
Originally published Dec 31, 2021 8:00:00 AM, updated December 31 2021