{"id":10196,"date":"2019-11-07T17:03:59","date_gmt":"2019-11-07T15:03:59","guid":{"rendered":"https:\/\/www.become.co\/blog\/?p=10196"},"modified":"2020-10-07T10:53:12","modified_gmt":"2020-10-07T07:53:12","slug":"profit-margin-formula","status":"publish","type":"post","link":"https:\/\/www.become.co\/blog\/profit-margin-formula\/","title":{"rendered":"What Is the Formula for Calculating Profit Margins?"},"content":{"rendered":"\n\n

Is your business in the black?<\/span><\/p>\n

That might sound a little ominous in other contexts, but when we\u2019re speaking about profit margin, believe us when we say you definitely want to answer \u2018yes\u2019 to that question.<\/span><\/p>\n

Being \u2018in the black\u2019 means that your business is earning more money than it\u2019s spending – or earning a profit. But how do you measure your profit margin ratio? And what is a profit margin as opposed to profit?<\/span><\/p>\n

Learn everything you need to know about profit margin below!<\/span><\/p>\n\n

What is the profit margin formula?<\/span><\/h2>\n

\"Profit<\/p>\n

Profit margin is a measurement that business owners use to determine how much money their company is earning per sale. As opposed to <\/span>gross profit or net profit<\/span><\/a> which are measured as an absolute dollar amount, the profit <\/span>margin<\/span><\/i> shows profits as a percentage of revenues. Regardless of whichever specific profit margin formula you\u2019re looking at (we get to that below), you\u2019ll always divide income by revenues.<\/span><\/p>\n

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Example<\/b>: A manufacturing company sells $600,000 worth of products, and the total expenses (labor, marketing, rent, raw materials, interest, taxes, etc.) equal $400,000. Subtract the total expenses ($400,000) from the net sales ($600,000) and you\u2019ll find the net profits equal $200,000.\u00a0<\/span><\/p>\n

To calculate profit margin, you\u2019d then divide the net profits ($200,000) by the net sales ($600,000), which would equal 33% for this example. That means for every $1 made in revenue, $0.33 is profit and $0.67 is used to pay expenses.<\/span><\/p>\n<\/blockquote>\n\n

You may be wondering why it\u2019s important to know your business\u2019s profit margin ratio as a percentage. Isn\u2019t it enough to know how much profit you\u2019re earning in terms of dollars and cents?<\/span><\/p>\n

To put it plainly, the reason you should take close notice of your profit margin as a percentage is that your <\/span>profit margin ratio<\/b> may change as your sales rise or drop, while your <\/span>net profits <\/b>may simultaneously remain the same.<\/span><\/p>\n

We\u2019ll continue with the example above to explain further:<\/b><\/p>\n\n

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The manufacturing company is able to increase its net sales to $800,000. But, in order to do that, they had to invest in hiring more workers, expanding on their marketing strategy, renting more space, and so on.<\/span><\/p>\n

Those changes raised the total expenses to $600,000. With these new values, the <\/span>net profits<\/b> will remain $200,000, but the <\/span>profit margin<\/b> will have dropped from 33% to 25%. That means for every $1 made in revenue, $0.25 is profit and $0.75 is used to pay expenses.<\/span><\/p>\n<\/blockquote>\n\n

As you can see, increased revenue (net sales) doesn\u2019t always mean increased profitability. That\u2019s why it\u2019s important to keep an eye on your business\u2019s profit margins.<\/span><\/p>\n

There are several variations of the profit margin formula that you\u2019ll use in succession, each of which provides a slightly different perspective on your business\u2019s performance. It\u2019s important to learn the differences between the different profit margin formulas so you can have the broadest and deepest understanding of your business\u2019s financial health.<\/span><\/p>\n

Let\u2019s get straight to it.<\/span><\/p>\n\n

1. Gross profit margin<\/span><\/h3>\n

\"Gross<\/p>\n

Gross profit margin measures how effectively your business is handling the direct costs of sales. This is the most general (and simplest) way to calculate profit margin, as it takes into consideration only the net sales and cost of goods sold (COGS).<\/span><\/p>\n

Although it provides somewhat limited insight, measuring the gross profit margin ratio does allow businesses to see how well they\u2019re performing in comparison to their competition.<\/span><\/p>\n

If other companies are able to provide the same service or product as you and maintain a higher gross profit margin ratio, it means they\u2019re either selling at a higher price or they\u2019re producing at a lower cost than your business. In other words, a higher gross profit margin ratio means more money retained for every dollar of revenue and less money put towards expenses.<\/span><\/p>\n

On the contrary, a lower gross profit margin means the direct costs of production are too high, your sales are too low, your <\/span>pricing strategy<\/span><\/a> can use some improvement, etc. – in any case, it means that your business plan is limiting your profitability and there are changes that need to be made.<\/span><\/p>\n

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You can use your gross profit margin to see how you compare to the industry standard and to your main competitors so that you\u2019ll gain a better sense of where you stand.<\/span><\/p>\n<\/blockquote>\n\n

2. Operating profit margin<\/span><\/h3>\n

\"Operating<\/p>\n

The operating profit margin formula is slightly different and a bit more complex than the gross profit margin formula. Operating profit margin is calculated by subtracting all operating expenses (as opposed to only COGS) from the revenue, then dividing by revenue. Multiplying the resulting value by 100 lets us see that amount as a percentage.<\/span><\/p>\n

By taking into consideration the indirect costs of operating the business (research, marketing, administrative expenses, etc.), this profit margin formula shows business owners how well those secondary investments are paying off. Remember, gross profit margin only measures your business\u2019s ability to handle the <\/span>direct<\/span><\/i> costs of sales in relation to revenue.<\/span><\/p>\n

Operating profit margin is also known as earnings before interest and taxes (EBIT) since this formula takes into account all expenses besides interest and taxes. This profit margin formula also gives business owners a clearer understanding of how much money they have available to pay debts, shareholders, and taxes.<\/span><\/p>\n

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Important: <\/b>It is possible that your gross profit margin can be high while your operating profit margin is low. That would be an indicator that your business is spending too much on things like research and marketing, and you should reassess how much you\u2019re investing in those areas.<\/span><\/p>\n<\/blockquote>\n\n

3. Net profit margin<\/span><\/h3>\n

\"Net<\/p>\n

The net profit margin formula is the final metric in this succession of profit margin formulas; it includes all expenses involved in running the business including direct costs of sales, indirect costs of sales, as well as taxes and interest.<\/span><\/p>\n

In other words, the net profit margin formula measures the relationship between net profits and net sales. This is what people are typically referring to when they ask about the profit margin ratio, which is why it\u2019s the first profit margin formula that we mentioned.<\/span><\/p>\n

Business owners can use the net profit margin formula to measure how effectively they handle the costs associated with their interest payments and taxes in relation to their revenue. If your gross and operating profit margins are relatively high, but your net profit margin is low, it means your business needs to either increase sales or decrease expenses.<\/span><\/p>\n

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Note:<\/strong> If your goal is to determine whether or not you’re earning enough money to pay off your debt, then take some time to learn about the debt service coverage ratio<\/a> (DSCR).<\/p>\n<\/blockquote>\n\n

How to calculate your profit margin using excel<\/span><\/h2>\n

If you\u2019re unfamiliar with the process, measuring your profit margin ratio may come off as a daunting task. Don\u2019t worry, you won\u2019t have to take night courses at your local community college to figure it out – we\u2019ve developed this quick & easy profit margin calculator for you to use…<\/span><\/p>\n

Simply open the calculator<\/strong> and then download or save a copy<\/strong> so that you can edit the numbers<\/strong> that reflect your business. Click here:<\/p>\n

Profit Margin Calculator<\/a><\/strong><\/span><\/p>\n\n

Click that link so you can follow our manufacturing company example we include in the profit margin calculator.<\/span><\/p>\n

Let\u2019s imagine we\u2019re looking at the income statement of a manufacturing business by the name of Generic Manufacturing Ltd. It looks like this:<\/span><\/p>\n


\"Net

<\/p>\n

Generic Manufacturing brings in $800,000 in <\/span>revenue<\/b>, spends $550,000 on the <\/span>COGS<\/b>, invests $150,000 on <\/span>operating expenses<\/b>, $10,000 on <\/span>interest<\/b>, and $26,000 on <\/span>taxes<\/b>.<\/span><\/p>\n

With those values, we can calculate the gross profit margin, operating profit margin, and net profit margin:<\/span><\/p>\n

GPM <\/i><\/b>= ($800,000 – $550,000) \/ ($800,000) x 100 = 31.25%<\/span><\/i><\/p>\n

OPM <\/i><\/b>= ($800,000 – $550,000 – $150,000) \/ ($800,000) x 100 = 12.5%<\/span><\/i><\/p>\n

NPM <\/i><\/b>= ($800,000 – $550,000 – $150,000 – $10,000 – $26,000) \/ ($800,000) x 100 = 8%<\/span><\/i><\/p>\n\n

What is the profit margin formula used for?<\/span><\/h2>\n

The profit margin formulas discussed here reveal lots of different information about a business\u2019s financial health, stability, and viability. Some of the insights to be gained from looking into the profit margin include:<\/span><\/p>\n