Putting time and money into your business only makes sense if you’re earning your investments back.
When you understand how to calculate profit margins, you’ll be able to determine when you’re meeting your goals and when a shift is needed.
In this article, we’ll explore what a profit margin is, the types of profit margins that exist, and how you can calculate them.
Keep reading to gain the knowledge you need to consistently make the best decisions for your business.
What Is a Profit Margin?
In short, your profit margin is how much your business income exceeds your business expenses.
This number is always expressed as a percentage to display how much your company is growing with respect to your expenses.
Every business owner should aim for as high a profit margin as possible.
A large percentage represents a strong, profitable company that is safe to continue on with its current business plan and practices.
On the other hand, a small percentage may be a sign that you need to make changes to raise your revenue or decrease your business expenses.
Don’t worry if your final percentage doesn’t sound impressive.
A 20% margin will actually get you an A+ and is considered ideal, and your margin isn’t truly considered low until you reach the 5% mark.
However, the average profit margin is 10%, so if your percentage begins falling below this, consider making some changes before you fall to the most undesirable numbers.
Types of Profit Margins
There are three different kinds of profit margins that every business owner should be aware of.
Each of them subtracts different kinds of expenses from your revenue — your total income before any deductions — to reveal strengths and weaknesses within your company.
Types of profit margins include:
- Your gross profit margin: This calculation describes your revenue after subtracting costs directly related to producing your goods or supplying your services.
These costs are known as COGS or “cost of goods sold.”
COGS includes direct labor expenses in addition to raw material expenses.
A high gross profit margin percentage means your company is efficient in producing your product.
- Your operating profit margin: This percentage represents your revenue after taking into account day-to-day operating expenses.
These include all overhead costs, like sales and admin expenses, but do not include anything that doesn’t feed into your operations directly (i.e. taxes and interest payments).
A good percentage is an indicator of great control over operations.
- Your net profit margin: Commonly known as a company’s bottom line, your net profit margin is the total revenue you’re left with after considering all costs.
This includes your cost of goods sold, operating costs, and even taxes.
Keeping this measurement healthy indicates an overall successful business that has good control over its total expenses.
It’s important for businesses to calculate all three of these types of profit margins, rather than picking and choosing.
Gathering the complete data is the only way to get the full picture of what is happening within the company, so you can pinpoint exactly where change is needed.
How to Calculate Profit Margins
Calculating profit margins may seem intimidating, but it’s actually done through easy plug-and-play formulas.
Entrepreneurs love using these margins as benchmarks due to their simplicity.
The following processes can be completed by just about anyone with their financial statements and a calculator.
Gross Profit Margin
Your gross profit margin will typically be the easiest percentage to calculate.
The formula is:
(Revenue – COGS) ÷ Revenue × 100 = Gross Profit Margin
As you can see, the only numbers you need to plug in are your revenue and your cost of goods sold, which are items that most businesses already track individually.
Let’s look at an example.
If a coffee shop’s revenue is $100,000 and its COGS is $85,000 — after adding the cost of coffee beans, barista wages, and other directly related items — you input the numbers like this:
(100,000 – 85,000) ÷ 100,000 × 100 = 15%
In the end, the coffee shop would be left with a 15% gross profit margin, which is an indicator of a healthy balance between production costs, the selling price of products, employee wages, and total sales.
If your number falls below 10%, you may want to re-evaluate your production process.
Some companies decide to mark up prices if they’re confident demand will stay the same, or to use more cost-effective materials.
Operating Profit Margin
Your operating profit margin formula is just as simple as your gross profit margin formula.
(Revenue – Operating Costs) ÷ Revenue × 100 = Operating Profit Margin
However, this calculation can be complex if you don’t have your operating expenses completely separated from your taxes, debt payments, and more indirectly related costs.
This is a common scenario for small business owners who are first launching their companies.
In this scenario, we recommend beginning to track your operational expenses as soon as possible, so you can track this profit margin in your next financial review.
This will allow you to understand the weight of your sales operations, administrative work, and other elements of your final income, allowing you to make changes as needed.
Net Profit Margin
The net profit margin formula is as follows:
Net Income ÷ Revenue × 100 = Net Profit Margin
While this formula may seem simple, your net profit margin calculation will require a few extra steps.
To gather your net income, you need to add together all of your expenses — cost of goods sold, operating expenses, interest, taxes, and anything else — and subtract that total from your revenue.
Because of this, the formula can also be rewritten as:
(Revenue – COGS – Operating Expenses – Interest – Taxes – Additional Business Expenses) ÷ Revenue × 100 = Net Profit Margin
No expenses are left behind in this calculation, so if you have yet to separate your expenses into these exact categories, don’t worry.
You can lump them all together, and your net income will still be accurate, so long as you have your revenue tracked correctly.
Frequently Asked Questions
It’s easy to become a business owner in the United States, but becoming a smart one requires you to study up and gain the knowledge you need to withstand the test of time.
Here, we’ll dive into a few frequently asked questions to help you understand what it really takes to be a successful entrepreneur.
1. How often should I calculate my profit margins?
Profit margins are usually calculated every quarter.
This time frame will allow your business to adjust and respond to any changes you’ve made since your previous profit margin calculations so you can see accurate trends.
At the same time, this three-month time frame is soon enough that you’ll be able to catch any areas where your profit is falling short.
By doing so, you’ll know exactly where to manage your costs and will never have to bandage up a gaping financial wound later on.
2. What category do credit card fees fall under?
Merchant fees can be considered a part of your cost of goods sold, as they are directly related to selling your goods or services.
At the same time, there is an argument that this is more closely related to operations since it’s a part of sales.
Others may argue that this is an unrelated cost altogether and should only be calculated in your net profit margin.
At the end of the day, the answer to this question really depends on why your business needed those credit card merchant fees and where you would like to categorize them as a business owner.
There are no official rules to how you categorize any fees, as long as the profit margins still tell you what they should.
3. Are contractor expenses considered in my gross profit margin or my operating profit margin?
Yes, these expenses should always be taken into account in at least one of these two types of profit margins, as they’re considered labor expenses — even if the laborer isn’t technically your employee.
If you’re running an advertising agency, for example, your freelance writers and designers should be considered part of your COGS.
Your virtual assistants, on the other hand, are part of your operational expenses.
Keep Profits High and Costs Low
Understanding how to calculate profit margins is essential for entrepreneurs, especially when your goal is growing your business.
In the modern gig economy, profit margins will help you consider how much you’re outsourcing to contractors and freelancers in comparison to the profit you’re making.
With this knowledge, you’ll be able to identify weak areas and make changes faster than your competitors.
If you’re getting ready to launch your first business, take a look at our guide to becoming an entrepreneur to get started.