Companies can use profit margin to assess the overall financial health of their businesses, also called their fiscal health. Companies may measure fiscal health using a few metrics, including by evaluating debt ratio, expenses, customer attraction and the amount of money they have in the bank.
In this piece, we’ll walk through the definition of profit margin, the types of profit margin (including gross profit margin, operating profit margin and net profit margin). We’ll also walk through how to calculate net profit margin and how you can apply it to your own business.
What is Profit Margin?
Why would a business need to pay attention to profit margins? Profit margin is one of the commonly used profitability ratios to gauge the degree to which a company or a business activity makes money.
What is a good profit margin? It can vary depending on the industry you’re considering. However, you can consider the following:
5%: Low profit margin
10%: Average profit margin
20%: High (good) profit margin
A good margin will vary considerably by industry and the size of the company. A 10% profit margin in certain industries may be a great profit margin compared to others.
Naturally, companies want to maximize their profit margin as much as possible, which you can achieve in a few different ways, including the following:
Reduce operating costs: How can you spend less in your business? You may be able to reduce the amount you spend on employee wages, unnecessary staff members, office space, limiting services or subscriptions, marketing and advertising, shipping, software, supplies and more. In addition, figure out whether you have expenses that are unnecessary. Can you adjust your expenses to improve your profit margin?
Evaluate current products: Adding better products (and getting rid of products that don’t perform as well) can be one way to increase profit margin.
Change pricing strategy: Changing the cost of your products can help you change your profit margins. You may be able to charge more for a certain product than you had in the past. Pricing will depend on the industry, your products and other factors like economic circumstances.
Cultivate brand loyalty: Customer loyalty matters. Keeping more customers latched onto your brand allows you to keep them as repeat customers. Customer retention costs a lot less than trying to attract new customers, so look to your existing customer base.
Automate certain tasks: What can you automate? Whatever you can automate can help you key responsibilities will almost always help reduce operating expenses.
There is no one way to identify one single way to increase your profit margin. In fact, you can try to identify a number of ways to increase profit margin and apply them to your business.
Types of Profit Margin
There are three main types of profit margin, including gross profit margin, operating profit margin and net profit margin. Let’s go over the definition of each as well as a few examples.
Gross Profit Margin
Gross profit margin, also often called the “gross margin ratio,” evaluates a company’s financial health by calculating the money left over from product sales minus the cost of goods sold — the direct cost of producing the goods. The gross profit margin, typically represented as a percentage of sales, is typically used for a specific product rather than the profit margin of a business as a whole.
Here’s how you calculate the gross profit margin:
Gross Profit/Revenue x 100 = Gross Profit Margin
Let’s take a look at a simple example. Let’s say your freelance video editing business makes $50,000 and the business costs you $10,000 in equipment.
First, figure your gross profit. In this case, your gross profit is $50,000 – $10,000 = $40,000.
Then, divide the gross profit by the amount of revenue you produce and multiply by 100 to get the gross profit margin as a percentage, like this:
$40,000 / $50,000 x 100 = 80%
In this example, the gross profit margin is 80%.
Operating Profit Margin
The operating profit margin refers to the earnings that a business generates from any operating activities. You can use the operating profit margin to gain insight into the performance of your business against competitors.
To calculate your company’s operating profit margin ratio, divide its operating income by its net sales revenue. First, you’ll need to determine the operating income, also called earnings before income and taxes (EBIT). Operating income refers to the income left on your income statement after you subtract operating costs and overhead (selling costs, administration expenses and the cost of goods sold).
Operating Income = Gross Income – (Operating Expenses + Depreciation and Amortization Expenses)
Then, you can calculate the operating profit margin like this:
Operating Profit Margin = Operating Income / Net Sales Revenue
How do you find your net sales revenue? The sales shown on your income statement are net sales. Otherwise, you can calculate net sales in the following way:
Net Sales = Gross Sales – Returns – Allowances – Discounts
Net Profit Margin
Net profit margin, also called “profit margin” or “net profit margin ratio,” is the type of profit margin used on an everyday basis because it provides a snapshot of a business’s profitability. In short, it’s a financial ratio used to calculate the percentage of a profit your company produces from its total revenue. It measures the amount of net profit a company gains per dollar of revenue gained.
Net profit margin helps you outline your company’s ability to produce profit and can be a metric for a company’s overall financial success.
How to Calculate Net Profit Margin
Let’s take a look at how to calculate net profit margin. It’s worth learning how to figure this type of financial analysis in order to determine whether your business is going the direction you want it to go.
The formula for net profit margin looks like this:
Net Profit Margin = Net Profit ⁄ Total Revenue x 100
First, you’ll calculate the net profit, which you can do by calculating the total revenue and subtracting all company expenses from this amount.
When you finish, you’ll have a final percentage. For example, a 20% profit margin means that for each $1 of revenue the company earns 20 cents in net profit.
Let’s take a look at an example. Let’s say the net profit of a company is $50,000 and the total revenue of that same company is $90,000. In this case, the net profit margin of a campy can be calculated like this:
Net Profit Margin = $50,000 / $90,000 x 100
The net profit margin is 55%.
Conclusion
Businesses (both small and large) use certain financial metrics to help them decide how to operate, including the types of profit margin we list in this article — gross profit margin, operating profit margin and net profit margin. Learn more about 10 common small business financial problems and how to solve them.
Whether you’re just starting your business or have a lot of experience, you want to know the metrics related to your company. In both your business and your personal finances, you want to manage your investments in line with your goals and risk tolerance. Personal Capital’s free finance tools can help you manage your entire financial life, from budgeting to long-term planning to portfolio analysis.
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Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.
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