How to calculate profit margins
Whether you run a construction company or a street food stall, profit margins are a big deal. They show how successful you are, as well as your potential for growth. But how do you calculate profit margins and what’s the difference between gross profit and net profit? Get started with our quick guide.
Whether you run a construction company or a street food stall, profit margins are a big deal. They show how successful you are, as well as your potential for growth. But how do you calculate profit margins and what’s the difference between gross profit and net profit? Get started with our quick guide.
What are profit margins?
Profit margins measure what percentage of your sales have made a profit. They’re one of the best indicators of how successful a business is.
Running a business isn’t just about how many units you can sell. It’s about how much profit you can make from the sale of each unit after deducting your day-to-day running costs and expenses.
For every pound your business makes, a percentage of this should be profit. This is the profit margin. For example, if your business has a 20% profit margin over a year, this means that 20p in every pound of your revenue was profit.
Revenue is the total amount of money you make from selling goods or services. As a business owner, your goal is to make a profit.
What is the formula for calculating profit margins?
Before we show you how to calculate profit margins, it’s important to be aware that there are three main types of profit. These are:
- gross profit
- operating profit
- net profit
You can calculate all of these by dividing the profit (revenue minus costs) by the revenue. Multiplying this figure by 100 gives you your profit margin, which is expressed as a percentage rather than in pounds. You work out each profit margin using a different measure of profit.
It’s important to understand the differences between these types of profit margin because each can help show a different aspect of your business’s financial health.
Use the calculations below to work out your percentage profit on gross profit, operating profit and net profit.
Gross profit margin
Gross profit is your total revenue minus costs directly associated with producing your product or service. In other words, it’s the difference between how much it costs you to make your product and how much you can sell it to customers for. Direct costs include raw materials and labour, but not overheads or taxes.
How to calculate gross profit margin
You calculate gross profit margin by subtracting the cost of goods sold (COGS) from total revenue, before dividing this figure by revenue and multiplying it by 100.
The formula for calculating gross profit margin is:
Gross profit margin = (revenue – COGS)/revenue x 100
Gross profit margin example
Let’s say you sell goods for £20,000, which cost £16,000 to make. Your gross profit is £4,000. Divide £4,000 by £20,000, which gives you 0.2. Multiply that by 100 and you get a total gross profit margin of 20%.
Operating profit margin
Operating profit is when overheads and admin costs are deducted from your revenue as well as cost of goods sold. These include rent, wages and energy bills but not interest and taxes. This shows how the day-to-day running of the business affects profit. It can be a useful indicator in helping you spot inefficiencies and overheads that hurt your overall profit margin.
How to calculate operating profit margin
Operating profit is calculated by subtracting all COGS and operating costs from the total revenue.
To work out the operating profit margin, divide your operating profit by revenue, before multiplying the figure by 100.
The formula for calculating operating profit margin is:
Operating profit margin = operating profit/revenue x 100
Operating profit margin example
Taking the same example as before, let’s imagine that selling the £20,000 goods incurred an additional £1,000 in operating costs. So:
- Add £1,000 to your gross profit of £16,000
- Subtract this from the £20,000 in revenue to leave you with £3,000.
- Divide £3,000 by £20,000 to get 0.15
- Multiply this by 100 to give you a 15% operating profit margin.
Net profit margin
Net profit is how much your business has earned after you’ve subtracted all your running costs, including overheads, business insurance and taxes.
This is the profit margin that’s most widely used because it shows how profitable a business is after all costs and expenses have been deducted from your revenue. You’ll know exactly how much money you have left to either reinvest, save or give to staff as a pay rise.
How to calculate net profit margin
Net profit is calculated by subtracting all associated overheads and expenses from the total revenue. To get the net profit margin, you divide your net profit by revenue and multiply by 100.
The formula for calculating net profit margin is:
Net profit margin = net profit/revenue x 100
Net profit margin example
If you paid £16,000 for materials, £1,000 in operating costs and another £1,000 in expenses on total revenue of £20,000, your net profit is £2,000. To work out the net profit margin, divide £2,000 by £20,000 to get 0.10, before multiplying that figure by 100. Your net profit margin is 10%.
Why do profit margins matter?
Profit margins are hugely important for any size and type of business, whether you’re a sole trader or employ hundreds of people.
With money flowing in and out of your business every day, it can be hard to keep track of how much you’re making overall. But by calculating profit over a certain period, say every month or three months (quarterly), you can keep a close eye on your business’s financial health. If you’re not making any profit, or barely making any money to cover your expenses, your business won’t be sustainable in the long run.
Not only are profit margins useful to give you an accurate picture of how your business is performing, they can also be vital if you need to secure a loan or outside investment.
From an operational point of view, they’re useful for tracking seasonal sales patterns, as well as overheads and other costs that might be placing an unnecessary strain on the business.
Frequently asked questions
Is profit the same as net income?
Yes, the terms net profit, net income, net earnings and bottom line essentially all mean the same thing. Accountancy jargon can be very confusing, especially if you’re new to business, but expect to find variations of these terms at the bottom of your income statement. This is a report you may need to produce to shows your business’s financial performance during a given period. That’s where the term ‘bottom line’ comes from when people talk about profit.
What are good profit margins?
There’s no ‘ideal’ profit margin you should be aiming for as it depends on the industry you’re in and what your overall business objectives are. But, generally speaking, a 10% net profit margin is considered average.
When setting your profit goals, it’s better to compare yourself with similar businesses to yours rather than aiming for a margin that’s unachievable.
You also need to set your profit margin against other important metrics like your cash flow and turnover to get a complete picture of your overall business performance.
How do I improve my profit margin?
There are several ways to increase your profitability. These will depend on your business’s specific objectives, but you could look to:
- reduce costs – a good place to start is by looking at ways you can cut costs. For example, could you negotiate better rates with your suppliers?
- increase revenue – if there’s enough demand for your product or service, perhaps you could consider putting up your prices, or step up marketing to attract new customers.
- boost productivity – can any processes be streamlined? Look into whether any new software or equipment can help you get more done in a shorter space of time.
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