How to Calculate Profit Margins

Passion, energy, and enthusiasm are essential entrepreneurial traits for launching a business — and so is an understanding of financial performance. To sustain and grow an LLC or Corporation, a business owner must keep an eye on its profitability. Calculating profit margin reigns as one of the most telling ways to assess a company’s financial standing.

What Is Profit Margin?

Profit margin measures your company’s profitability after deducting expenses from its revenue. It’s expressed as a percentage — indicating the ratio of profit to revenue.

For example, if your business has a 30% profit margin, it means your company has $0.30 profit for each dollar in revenue.

As profit margins are vital key performance indicators (KPI), it’s helpful for companies to calculate them monthly, quarterly, and annually to keep a pulse on their financial performance month-by-month, seasonally, and for the entire year.

For a comprehensive view of a company’s financial health, it’s helpful to calculate three types of profit margins:

• Gross profit margin
• Operating profit margin
• Net profit margin

Each has a slightly different formula, providing insight into where a company stands at various points in its income (profit and loss) statement.

Gross Profit Margin

Gross profit margin looks at revenue compared to the costs to create products or provide services. Generally, gross profit margin helps business owners understand the profitability of products and services rather than the company’s profitability overall.

Before calculating gross profit margin, you must calculate gross profit.

Gross Profit Formula:

Calculating gross profit involves subtracting the cost of goods sold (e.g., materials, manufacturing costs, labor, and other expenses directly related to making products or providing services).

Gross Profit = Gross Revenue – Cost of Goods Sold

Gross Profit Margin Formula:

Next, you can calculate your gross profit margin by using the formula:

Gross Profit Margin = (Gross Profit ÷ Revenue) x 100

Gross Profit Margin Example:

Suppose your company’s annual revenue is $800,000 and your cost of goods sold is $300,000.

Your annual gross profit would be $500,000 (i.e., $800,000 – $300,000), and your gross profit margin would be 62.5%, using the formula ($500,000 ÷ $800,000) x 100.

Operating Profit Margin

Operating profit is the income remaining after costs of goods sold and operating expenses — in other words, gross profit minus operating expenses gives you your operating profit. Examples of operating expenses include rent or mortgage payments, payroll, utilities, etc.

Operating Profit Formula:

Operating Profit = Revenue – (Cost of Goods Sold + Operating Expenses)

Operating profit margin expresses operating profit as a percentage of a company’s revenue.

Operating Profit Margin = (Operating Profit ÷ Revenue) x 100

Operating Profit Margin Example:

Suppose your annual revenue is $800,000, your total cost of goods sold is $300,000, and your operating expenses are $300,000. Your operating profit would be $200,000 (i.e., $800,000 – $600,000).

Your operating profit margin would be 25%, using the formula ($200,000 ÷ $800,000) x 100.

Net Profit Margin

Net profit margin is what people refer to as a business’s “bottom line.” It not only considers the cost of goods sold and operating expenses but also taxes, interest, and other expenses. In short, it’s the revenue you have left after all costs are accounted for.

Net Profit Margin Formula:

First, calculate net profit by subtracting all of your expenses from your revenue.

Net Profit = Revenue – (Cost of Goods Sold + Operating Expenses + Taxes, Interest, and Other Expenses)

The formula for calculating net profit margin is:

Net Profit Margin = (Net Profit ÷ Revenue) x 100

Net Profit Margin Example:

Suppose your annual income and expenses are as follows:

• Revenue = $800,000
• Cost of goods sold = $300,000
• Operating expenses = $300,000.
• Taxes and interest = $60,000

Your net profit would be $140,000 (i.e., $800,000 – $660,000).

Your operating profit margin would be 17.5%, using the formula ($140,000 ÷ $800,000) x 100.

What Is a Good Profit Margin?

Typical profit margins vary widely across different industries.

Aswath Damodaran, professor of corporate finance and valuation at Stern School of Business at New York University, has researched profit margins by industry. I’ve included some of his findings in 2023 below to illustrate the variance between different types of business.

Gross, Operating, and Net Margins by Industry

It’s not always an “apples to apples” comparison when looking at the profit margins of different companies in different business sectors as indicators of success and viability.

For example, a grocery store that sells a high volume of low-priced items will likely have a lower net profit margin than a jewelry store with high-priced products but low sales volume. While the grocery store has a lower profit margin, it may be much more sustainable because it generates more income while maintaining a profit.

Also, companies with high depreciation costs (e.g., for equipment and other significant purchases) will likely have a lower net profit margin despite having a healthy cash flow.

Therefore, it’s critical to consider other financial reports and metrics as well — such as cash flow statements, balance sheets, and EBIDTA (earnings before interest, taxes, and amortization). Fortunately, if you use an accounting software solution, you have access to a variety of financial reports that will help you evaluate your company’s financial health.

For assistance understanding your profit margin and what it may indicate for your business, consider talking with an accounting professional for insight and advice to help your company achieve financial success.