Profit margin is a critical figure for any business because it helps you understand how much money your company is making.
What Is Profit Margin?
Profit margin is a measure of the profitability of a business. It is presented as profit earned by a business compared to how much total revenue flowed in over a specified period.
Profit margin is expressed as a percentage.
Business owners, lenders, investors, and other stakeholders use profit margin to understand how much profit a business is earning off every sale of a good or service.
Several different types of profit margin are commonly used in business documentation: gross profit margin, operating profit margin, pre-tax profit margin, and net profit margin. The chief difference between these is how they incorporate various expenses.
Why Should I Care About My Profit Margin?
While some high-profile companies run at a loss, you most likely started a business to make money. Therefore, you probably want your small business to turn a profit. Not only does earning profit allow you to keep your doors open, but it gives you the resources to expand your company.
Even if you aren’t particularly concerned with profitability—perhaps your business is brand new—your profit margin is an important figure to know. Different industries have different profit margin expectations; by calculating your business’ profit margin, you can see how you are doing versus your competitors.
What Is Gross Profit Margin?
Your gross profit margin expresses how much money you directly earn off each product or service you sell. It takes into account the expenses directly involved in production, like raw materials.
To calculate, subtract the cost of goods sold (COGS) from your total revenue. Divide this number by your total revenue to determine your gross profit margin percentage (in decimal form).
COGS refers to the direct expenses associated with each good you sell (i.e., the cost of manufacturing or acquiring your goods). This does not include indirect costs, such as rent for your office.
Your gross profit margin is important from an accounting standpoint because it is used in creating profit and loss statements, also known as income statements.
What Is Operating Profit Margin?
Operating profit margin goes a little further than gross profit margin because it incorporates more expenses than just COGS. This figure takes into account all the expenses, like rent or marketing, needed to keep your business operating. However, do not include taxes or interest as expenses when calculating operating profit margin.
Divide your operating income by your net revenue to calculate your operating profit margin.
What Is Pre-Tax Profit Margin?
Pre-tax profit margin shows your company’s profitability before taxes. Divide your pre-tax earnings by net revenue to calculate pre-tax profit margin.
What Is Net Profit Margin?
Net profit margin takes into account all of your expenses, including taxes, so it is commonly seen as the most important type of profit margin by many lenders and investors. This is your business’ “bottom line.”
Calculate your company’s operating profit margin, then subtract tax and interest expenses. Divide this number by your total revenue to determine your net profit margin.
What Should My Profit Margin Be?
Profit margin varies by industry and region—restaurants infamously have a reputation for very small profit margins, for example. You can research your industry to figure out what profit margin you should expect for your type of small business.