Understanding your business’s profit margin is essential for determining its growth potential and financial stability. It’s also a useful tool that allows you to see how your business compares to others in the same industry, as well as finding ways to better manage your cash flow.
What is Profit Margin?
Your business’s profit margin is a percentage that represents the value of each dollar of revenue (total business earnings) after taking into account any business-related expenses. For example, if you have a 30% profit margin, that means you earn $0.30 for each dollar of revenue.
There are three types of profit margins: gross, operating, and net.
Gross Profit Margin
Gross profit margin is your business’s profitability in its simplest form as it only accounts for cost of goods sold (COGS) when determining the margin. COGS are those expenses specifically involved with the production and manufacturing of products or services, from materials to labor costs. Gross margin does not include taxes, debts, overhead, or operating costs.
Use this formula to calculate gross profit margin:
Gross Profit Margin = ((Revenue — COGS) / Revenue) x 100
Operating Profit Margin
Operating profit margin is focused exclusively on overhead and operating expenses to represent how much profit your business generates in comparison to essential expenses that keep your business running. Before calculating your operating profit margin, you must first determine your total operating profit by taking the revenue and subtracting all overhead, operating, administrative, and sales expenses.
Use this formula to calculate operating profit margin:
Operating Profit Margin = (Operating Income / Revenue) x 100
Net Profit Margin
Net profit margin is useful when starting a business or looking to improve profitability, as it reflects your business’s potential for turning income or revenue into profit. It takes your net income—or bottom line—and sets it against your total revenue to generate a percentage reflecting how much your business is really earning for every dollar of revenue.
Unlike gross or operating profit margins, which only account for a select portion of your business expenses, net profit margin takes all costs into account to show how much you’re really profiting after covering every expense. Before calculating your net profit margin, you must first determine your net income by subtracting all COGS, operating expenses, interest, taxes, and any other expenses from your revenue.
Use this formula to calculate net profit margin:
Net Profit Margin = (Net Income / Revenue) x 100
What is a Good Profit Margin?
Because profit margins vary greatly depending on your sector or industry, there is no set standard for what makes a “good” profit margin. An e-commerce business cannot compare their profit margin to a construction company as they will have entirely different overhead, COGS, revenue, etc. You should always look at your profit margin in comparison with other businesses in your industry, otherwise it’s like comparing apples to oranges.
There is also a certain level of subjectivity to profit margins, as it really depends on your own business goals. In general, a profit margin between 5% and 20% is considered good.
How to Calculate Profit Margin
When calculating net profit margin, you’ll need to track a lot of different expenses. Using spreadsheet software such as Google Sheets or Excel can make tracking and calculating a lot easier.
To understand the overall profitability of your business, you’ll want to calculate the net profit margin:
- Add together all business expenses (COGS, overhead, operating expenses, taxes, debts,etc.)
- Calculate net income by subtracting your expenses from your revenue
- Divide net income by revenue
- Multiply this figure by 100 to generate a net profit margin percentage
Example: E-Commerce Business
If an e-commerce business wants to understand their net profit margin, they must first know their business expenses and net income. For the purposes of this example, the expenses are as follows:
- COGS: $3,000
- Operating expenses: $1,500
- Other expenses: $1,000
- Debts: $500
- Taxes: $1,000
Their total expenses, therefore, add up to $7,000. With a revenue of $10,000, this makes their net income $3,000.
Net Profit Margin = (Net Income / Revenue) x 100
= ($3,000 / $10,000) x 100
= 0.30 x 100
Net Profit Margin = 30%
If this e-commerce business is more interested in their gross profit margin, however, they need only calculate their gross profit, or their income after accounting for costs of goods sold:
Gross Profit Margin = ((Revenue – COGS) / Revenue) x 100
= (($10,000 – $3,000) / $10,000) x 100
= ($7,000 / $10,000) x 100
= 0.70 x 100
Gross Profit Margin = 70%
Standard Profit Margins per Sector
Once you have calculated your business’s unique profit margin, you should compare it to the industry standard in order to understand your relative positioning. Here are a few net and gross profit margins for common industries:
|Industry||Net Profit Margin||Gross Profit Margin|
|Business & Consumer Services||5%||31%|
Profit margins are valuable key performance indicators (KPIs) for any business and should be evaluated regularly. When a business has seen a significant growth or decrease, you should recalculate your profit margin as this may have shifted as well. If you are looking to improve a poor margin, the first place you should look is at your costs. Attempting to increase sales will also increase your expenses, which will ultimately leave your profit margin in the same relative position.
Consider ways you can cut business costs, including by eliminating underperforming products or services, seeking less expensive vendors or fulfillment providers, and looking for alternative solutions in your processes that will be less costly. This is another reason why knowing your profit margin is so valuable—it can help you identify waste and unnecessary spending in your processes to build a more sustainable business that is ready to grow and scale over the long term.