It’s true what they say: numbers don’t lie. And if you want to understand how profitable your company is, how you compare to the competition, and how attractive you are to investors and lenders, then keep an eye on your business’s profit margin.
But what exactly is the profit margin?
The profit margin is a financial ratio used to determine the percentage of sales that a business retains as earnings after expenses have been deducted. For example, a 20% profit margin indicates that a business retains $0.20 from each dollar of sales that it makes. By factoring in business expenses, the profit margin determines how well a company is able to manage expenses relative to sales, which makes it a good indicator of a company’s profitability and overall financial health.
What are the different types of profit margins?
There are three types of profit margins, and each one reflects the different costs, taxes, and overhead expenses incurred in specific operational areas of the business. Each type also has a different formula. The components for these formulas (e.g., cost of goods sold and sales revenue) are included in the income statement section of a company’s financial statement.
These three types of profit margins should be used in concert to measure a business’s health and benchmark performance with other companies.
Gross profit margin
The gross profit margin is used to determine the profit margin of a specific product or service rather than the entire business. Understanding the gross profit margin can help with your pricing strategies as well as determining which items are the least and most profitable.
The gross profit margin is the simplest profitability metric because it defines profit as the income remaining after factoring in cost of goods sold (COGS), also known as cost of sales. The cost of goods sold only includes expenses directly related to the production or manufacturing of a product, such as the wages paid for labor and raw materials used throughout the process.
However, this figure excludes taxes, debt, fixed costs, overhead expenses such as utilities or rent, and one-time expenses such as equipment purchases.
The gross profit margin is a good yardstick for measuring the relative profitability of different products. A high gross profit indicates that you’re generating profit from a product, while a low margin signifies that your sale price is not much higher than the cost.
The gross profit margin formula is:
[(Total Revenue – Cost of Goods Sold) / Total Revenue] X 100
To find the gross profit margin on a particular product you offer, you would need the price of the item (revenue) and the cost to make the product (COGS).
For example, let’s say you run a clothing store and sell T-shirts for $20 each, and it costs $10 to make each T-shirt (COGS). Here’s how you would find your gross profit margin:
[(Total Revenue – Cost of Goods Sold) / Total Revenue] X 100
Gross Margin = [($20 – $10) / $20] X 100
Your business’s gross profit margin is 50% or 0.50. This means you make 50% on every T-shirt you sell.
Operating profit margin
The operating profit margin is the total income a company generates from sales after it has paid off all of its operating costs. Unlike the gross profit margin, which only factors in the direct costs involved in production, the operating profit margin looks at the day-to-day business expenses, such as operating, administrative, sales, and overhead costs. As such, the operating margin gives a clear picture of the percentage of each dollar that remains after the business has paid for all its day-to-day expenses. This ratio also factors in amortization rates and asset depreciation but excludes non-operational expenses like taxes and debts.
The operating profit margin is important because it helps determine how profitable the core operations of the company are. A higher operating margin is preferable to a lower one because it shows that the business is making enough money to pay for all of the associated costs involved in operating it.
The operating profit margin formula is:
Operating Income / Revenue X 100
The operating profit margin for a business with an operating income of $12,000 and revenue of $50,000 would be calculated in the following manner:
Operating Income / Revenue X 100
($12,000 / $50,000) X 100 = 24%
The company’s operating profit margin would therefore be 24% or 0.24.
Net profit margin
The net profit margin is the most complex and comprehensive profitability ratio of the three. This margin measures how much net income (also known as net profit, net earnings, or bottom line) is left over after all expenses and income have been deducted from a company’s revenue.
Unlike the previous two ratios, the net profit margin not only includes the cost of goods sold and operational expenses but also payments on debts, taxes, one-time purchases, and income from investments. Therefore, the net profit margin calculation shows the profitability of an entire company, not just a single product or service. As such, it is a good way to measure a company’s overall ability to turn income into profit. When people refer to a company’s “profit margin,” they are usually referring to the net profit margin.
Overall, a high net profit margin suggests that a company is efficient at converting revenue into actual profit. Meanwhile, a lower ratio could be indicative of weak pricing strategies, high costs, or inefficient management.
The net profit margin ratio or formula is:
[(Revenue – COGS – Operating Expenses – Other Expenses – Interest – Taxes) / Revenue] X 100
or
(Net Income / Revenue) X 100
For example, let’s say you have a company that has a total revenue of $600,000 with a total cost of goods for the year of $5,000. You pay $200,000 in salaries, $5,000 in taxes, and $50,000 in operating expenses.
To calculate your net margin using either one of the formulas above:
[(Revenue – COGS – Operating Expenses – Other Expenses – Interest – Taxes) / Revenue] X 100
[($600,000 – $5,000 – $200,000 – $5,000 – $50,000) / $600,000] X 100
or
(Net Income / Revenue) X 100
[($600,000 – $260,000) / $600,000] X 100
Your business’s net profit margin would be 56% or 0.56
What is a good profit margin?
Profit margins vary depending on the industry and company size and can also be impacted by a variety of other factors such as location, the state of the economy, and how much competition a business has. There is no magic formula, but as a general rule of thumb, 5% is considered a low margin, 10% an average profit margin, and 20% a high margin.
Overall, it’s unrealistic to compare a supermarket, for example, to an art gallery. Supermarkets and retailers have fast inventory turnover and, therefore, tend to have low-profit margins since they are selling more units. They also have more operating costs because they need to purchase inventory more frequently, hire employees, handle shipping and distribution, etc. An art gallery has a slower inventory turnover; therefore, margins are higher since fewer items are being sold.
Startups or new businesses may have lower profit margins than more established companies because they may have smaller economies of scale, lower prices, or must offer discounts to gain market share.
According to data from NYU, industries with the highest profit margins are banks, financial services companies, and pharmaceuticals. Makers of luxury goods and software-as-a-service (SaaS) companies also tend to be able to consistently generate high-profit margins. This is because these industries tend to have fewer operational overheads and lower inventory and are able to gain an advantage by branding or patenting their products or providing services that have little to no competition. You can learn more about the companies and industries that generate the most profit per employee in our list of rankings.
Because profit margins vary drastically by industry, overall, a good profit margin is one that meets your business goals.
Healthy profit margins are key to business success
Carefully monitoring your profit margin will help your business stay financially afloat and enable you to make informed decisions about your business and its operations. Each of these margins provides a different window into your profitability, and each will impact how you approach hiring, pricing, and marketing.
Further reading
