Figuring how much money your business is making is critical to its continued existence and future success. Equally important is determining your business’s expenses — both direct and indirect costs — and their impact on your bottom line, which is your net profit. Profit margins are one of the simplest and most widely used ways of measuring business finances. They’re financial ratios that are calculated based on profits versus total revenue brought in. Read on to find out the various types of profit margins and the formulas for calculating them.

What Is Profit Margin?

Profit margin is one of the most common profitability ratios used by businesses to measure the degree to which a company makes money. Essentially, a business’s profit margin represents what percentage of sales have been turned into profits.  If percentages aren’t your thing, another way to look at profit margin is by viewing it in terms of how many cents of profit the business has generated per dollar of sale. For example, if a business reports that it attained a 50% profit margin during the last quarter of last year, then it had a net income of 50 cents for each dollar of sales made by the business. Note that there are several types of profit margin, such as gross profit margin, operating profit margin and net profit margin. The latter is most likely the form referred to as simply “profit margin” in everyday talk. A business’s net profit margin is its bottom line after all other expenses are subtracted from revenue.

Profit Margin Formula: How To Calculate and Evaluate

Because there are various types of profit or profit margins, there are also multiple formulas for calculating profit margins. The simplest formula for profit margin, specifically net profit margin, is as follows:

• Profit margin = (Net income / Net sales) * 100

While simple, this formula has terms in it that need to be calculated before you can figure out the net profit margin. For example, net income comes from total revenue minus business expenses. Net sales, on the other hand, is gross sales minus discounts, returns and allowances. You’ll need to calculate those first for this formula to work. Put another way, a basic profit margin formula can look like this:

• Profit margin = ((Sales – Total expenses) / Revenue) * 100

The process of determining your business’s profit margins goes through a series of steps, generally observable in a company’s financial or income statement. Here’s how the sequence of determining profit margins happens.

Gross Profit Margin

First, the business brings in sales revenue, then pays direct costs of the product or service, often referred to as the cost of revenue or cost of goods sold. These costs are directly related to creating or providing the product or service, such as raw materials, labor and similar expenses. To get the gross profit margin, you first determine gross profit:

• Revenue – COGS or Cost of Revenue

This is then followed by determining net sales:

• Revenue – Cost of Sales Returns, Allowances and Discounts

Leading to a gross profit margin formula as follows:

• (Gross profits / Net sales) * 100

This is the first form of profit and profit margin that results from running through the income statement. After this round, which included subtracted direct costs, comes another round in which indirect costs play a key role.

Operating Profit Margin

With direct costs taken out of profits, now it’s time for indirect costs. These can include costs associated with selling and administration, overhead, company headquarters, advertising, R&D and similar.  When you subtract the costs of selling general and administrative expense — also known as SG &A — and other indirect costs from your company’s gross profit number, you get operating profit margin. This is often referred to as earnings before interest and taxes or EBIT. To calculate operating profit margin, you need to get operating profit first. This comes from taking gross profit, which is revenue minus COGS, and subtracting all operating expenses, from salaries and benefits to rent and overhead to depreciation and amortization.  Once you have an operating profit, the formula for operating profit margin is:

• (Operating profit / Revenue) * 100

Your operating profit or operating income represents the money available to pay your business’s debt, equity holders and taxes. Put another way, operating profit is profit from a company’s principal, ongoing operations.

Net Profit Margin

Net income, your company’s bottom line, represents the total amount of revenue left over after you account for all expenses and additional income. That means subtracting COGS and operational expenses as well as payments on debts and to equity holders, interest, taxes, one-time expenses or payments and any other extraordinary items.  Essentially, the net profit margin represents your company’s overall ability to convert income into profit. There are two ways to represent net profit margin formula, one more spelled out and the other short:

• ((Revenue – COGS – Operating expenses – Other expenses – Interest – Taxes) / Revenue) * 100
• (Net income / Revenue) * 100

Now that you know these three sets of profit and profit margin types, take a look at an example that covers all the stages of calculating profit margins.

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Example of Calculating Profit Margins

The table below features some of the key terms in bold, while items that are not bold are subtracted from the bold values. At the top, you begin with your total revenue — in bold — subtract the cost of revenue or COGS — not bold — to get gross profit.

As you can see, a company’s revenue is a vastly different metric than net profit or net income. And, for this hypothetical company, the cost of revenue and operating expenses actually aren’t too bad. In the final three rows, you’ll find the profit margins calculated in percentage form:

• Gross profit margin comes from dividing the gross profit row by revenue.
• Operating profit margin comes from dividing the operating profit row by revenue.
• Net profit margin comes from dividing the net profit row by revenue.

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The Bottom Line: Why Profit Margin Is Important

Tracking your profit margins is very important to running a successful business. For one, calculating and understanding your profit margins can help your company grow by identifying excessive spending or underperforming products and practices involved with your business. Profit margins of all types are helpful data to have on hand when evaluating how well your business is doing as it grows and expands. What’s more, studying your profit margins can help you spot red flags and other areas of concern. For example, if your profit margin is low, you might be experiencing pricing errors, expense management or accounting problems.  The different levels of profit margins — gross profit, operating profit and net profit — each can provide good insight toward flagging issues. If your gross profit is climbing over the years, but operating profit is declining, operating expenses are getting out of hand and need to be addressed.

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The last reason profit margins are important is because they’re standard financial practice with businesses. If your company produces an income statement, all these values will be included.  Not only that, since profit margins are part of your financial statements, lenders are going to want to know them. Your company could already be making millions, but if lenders can’t tell if you’re truly profitable, it could be more difficult to secure financing. The most valuable part of determining your company’s profit margin is that it allows you to see how many revenue dollars are actually contributing to your bottom line, and how many dollars are going toward your business expenses. Armed with this metric, you can figure out how to price your product or service and which expenses to try and reduce.

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