Profit: every business owners’ goal. When you’re losing money, all you want to do is eventually turn a profit. And when you’re turning a profit, all you want is bigger profits. It’s what drives businesses to make sales, cut expenses, and become a mean, lean operating machine.
Profit margins are one of your most important business metrics. Fortunately, it’s also one of the easiest ones to calculate.
Below, we’ll show you what profit margin is (and isn’t), and then cover how to calculate your profit margin.
What Is Profit Margin?
Your profit margin is a figure that illustrates your business’s level of profitability. It’s usually expressed as a percentage, and the higher that percentage, the more profit your business is earning.
Businesses primarily use 2 types of profit margins to measure their business’s success: gross profit margin and net profit margin.
Gross profit margin: Measures the effectiveness of your pricing strategy—but it won’t tell you if your business is actually turning a profit.
Net Profit Margin: Looks at your total net income and sales to evaluate your business’s ability to turn revenue into profit.
How to Calculate Your Profit Margin
First, let’s look at calculating your gross profit margin:
Gross Profit Margin = Net Sales / (Net Sales – Cost of Goods Sold)
Your net sales are the total revenue minus the costs of any returns, allowances, or discounts. Cost of goods sold (COGS) is all of the expenses directly associated with the production of your goods or services, such as direct materials and labor costs.
Next, let’s calculate your net profit margin:
Net Profit Margin = (Net Income / Net Sales) x 100
Your net income is the amount of revenue left over after you’ve subtracted all the expenses. To determine your net income, take a look at our Quick and Easy Guide to Calculating Your Net Income.
How to Use Your Net Profit Margin
Once you’ve calculated your net profit margin, it’s time to put that percentage to good use. Your net profit margin will tell you if your business is headed in the right direction. By analyzing and reporting this number on a monthly, quarterly, and annual basis, you can see the up and down trends with your business’s health.
Profit margins will vary per industry, so you’ll need to check your industry-averages to see if you’re on the right track. Industry-average margins act as benchmarks to quickly measure your business’s health.
If you have a high profit margin (relative to your industry), that’s an indicator that your business operations are efficient and healthy. A low profit margin indicates weak sales, high expenses, incorrect pricing, or low demand for products and services—you’ll need to dive deep into the numbers and your business strategy to pinpoint the inefficiencies.
Your profit margins are an evolving part of your business. When you make financial plans, you’ll create profit margin expectations and steer your business towards those goals. Later, you’ll calculate your profit margins to see if you’re on track and what needs to change for you to be satisfied with that percentage.
Getting your profit margins right could make the difference between success and failure, so take the time to understand and prioritize this metric.