If you are new to the business world, your head has, no doubt, been spinning. Not only must you keep track of all the ins and outs of running your business, but there are also laws to comply with, paperwork to fill out, taxes to pay, and so on.
You’re probably also slowly adapting to what can, at times, seem like a new language. As you begin to fill your mental glossary with terms like “liabilities, “amortization,” “net income,” “depreciation,” and more, ZenBusiness is here to help. After all, knowledge is power, and by understanding important business terms and how they are used, you’ll be on the path to growing your business with confidence in no time.
In this article, we describe what profit margins are in the business world and go over why they’re important to you, even if you’re a small business owner who hasn’t generated a profit yet. We’ll also go over the steps for calculating profit margins in a way that makes sense even to the most math-phobic and include examples to further illustrate how it all works.
What are profit margins?
A profit margin is a number, often represented as a percentage, that provides a measure of how much money your business is bringing in after accounting for costs and expenses. You can think of it as the proportion (or percentage) of your revenue (total money coming in) that is left over after subtracting the money you’ve paid out for different reasons.
If your company’s profit margin is 0%, all the money you make is going to expenses. A positive profit margin, such as 35%, indicates that you are making a profit. A negative profit margin, such as -35%, indicates that your business is losing money — something not uncommon for new businesses in their first years. A good profit margin is one that is a positive percentage.
Calculating and monitoring changes to profit margins and other metrics allows you to track the overall financial health of your business. It can also help you make informed decisions about changes to your business in the future — in other words, avoid the common, costly mistakes many other small businesses make as they’re starting out.
3 Types of Profit Margins
Here’s where it gets a little more complicated: There are three types of profit margins. Not to worry, though, because we’re here to break them down for you, explain why each one is important, and point out what they tell you about your business.
The three main types of profit margins are:
- Net profit margin
- Gross profit margin
- Operating profit margin
Net Profit Margin
The net profit margin is the profit margin you are most likely already picturing in your mind. It’s found by taking into consideration the total of all expenses associated with your business. This includes things like materials costs, shipping, electricity, office space, internet, interest, taxes — any money that you have paid in the course of doing business.
Now, consider your total amount of revenue, or money that has come in, and subtract all of these expenses from that. This gives a quantity called your “net profit,” sometimes referred to as your “bottom line.” It’s the amount of money you’re really making after considering expenses.
Your net profit is turned into a net profit margin when you divide it by revenue. This division will yield a decimal number that you can multiply by 100% to turn it into a percentage. How to perform this calculation is discussed in more detail below. For now, just know that the net profit margin is a measure of your business’s total net profit after accounting for every possible expense.
Gross Profit Margin
The gross profit margin only takes into account expenses associated with creating the product being sold. It doesn’t take into account all of the overhead expenses or other costs of running your business.
Frequently, the gross profit margin is used on a smaller scale to describe the profitability of certain products you sell or services you render. For example, suppose you build handmade furniture. The expenses to consider in calculating the gross profit margin of, say, chairs would be the wood, nails, glue, or other materials you had to purchase to make each chair. (These are collectively called the “costs of goods sold,” often abbreviated as “COGS.”)
When determining the gross profit margin, you first find the gross profit, or net sales, which is the amount you get after subtracting the COGS from the revenue, or money made when you sell the item. Just as with the net profit margin, this value is divided by revenue to find the gross profit margin. (Don’t worry, we’ll show you some examples of this being calculated in just a bit.)
If you compute the gross profit margin on different items you sell or services you render, you can compare the profitability of each. Items with higher profit margins make you more money than items with lower profit margins. You may use this information to shift your focus to more profitable items and/or change the sale prices of items.
Operating Profit Margin
The third type of profit margin is called the operating profit margin. At first glance, the operating profit margin sometimes looks very similar to the net profit margin, but there is a key difference. The expenses that the operating profit margin takes into account include overhead, COGS, and all operational expenses associated with running a business, but it doesn’t include taxes or debt payments.
Basically, it excludes costs that exist as an extension of your business and its activities. For example, you don’t pay taxes unless you have business income coming in. And you don’t pay on debts as part of the day-to-day operating of your business. In this way, the operating profit margin gives you an idea of how much money your business activities make without also having to consider what you will owe in taxes on that money or what you need to repay on loans.
How to Calculate Your Profit Margins
Now that you know what the three profit margins are and what they tell you about your business, it’s time to get down to the math. Here, we break down the formula for each so that you can get started calculating your profit margins now.
It’s important to perform these calculations even when you are just starting, because it will provide baseline numbers that you can compare as your business grows. Even if you haven’t generated revenue yet, you may wish to make future profit margin projections using estimated numbers from your business plan so that you can tell if you are on track or if you need to change your pricing strategies.
Net Profit Margin Formula
As described, the net profit margin percentage is essentially your net profit divided by your revenue, multiplied by 100 to turn it into a percentage. So, simply put:
Net Profit Margin = (Net Profit/Revenue) × 100
Recall that revenue is the total income that your business brings in. It has nothing subtracted from it. Net profit can be broken down as the difference between revenue and all expenses:
Net Profit = Revenue – COGS – operating expenses – other expenses – interest – taxes
Gross Profit Margin Formula
The gross profit margin is calculated as follows:
Gross Profit Margin = (Gross Profit/Revenue) × 100
Here, the gross profit is simply the revenue minus COGS only.
Operating Profit Margin Formula
The operating profit margin is calculated similarly:
Operating Profit Margin = (Operating Profit/Revenue) × 100
In this case, the operating profit, or the operating income, is the difference between revenue and all COGS and operating expenses, except interest and taxes:
Operating Profit = Revenue – COGS – operating expenses
Example Profit Margin Calculations
Below are two examples to give you a sense of how these calculations work. The first is geared toward a full-time business owner (think someone managing their own LLC), and the second is geared toward someone working a side gig outside of their full-time job.
Scenario 1: Bella builds furniture
Bella has a full-time business building furniture. She crafts her pieces by hand and makes them out of wood. The following table shows all revenue and expenses associated with her business over the course of one month:
|Chair sales revenue||$4,500|
|Table sales revenue||$2,000|
|Cost of Goods Sold (COGS)|
|Cost of materials for chairs||$3,000|
|Cost of materials for tables||$1,400|
|Total Cost of Goods Sold (COGS)||$4,400|
|Tools and supplies||$100|
|Total Operating Expenses||$1,220|
To calculate Bella’s net profit margin, first calculate her net profit by subtracting the total of all expenses and COGS from the total revenue: $6,500 – $4,400 – $1,345 = $755. Then, divide this amount by the total revenue and multiply it by 100 to make it a percentage: ($755/$6,500) × 100 = 11.6%.
To calculate the gross profit margin on chairs, subtract the COGS for chairs from the revenue for chairs, divide by the revenue, and multiply by 100: [($4,500 – $3,000)/$4,500] × 100 = 33.3%
To calculate the operating profit margin, calculate the operating profit by subtracting operating expenses and COGS from the total revenue: $6,500 – $4,400 – $1,220 = $880. Then, divide this amount by the total revenue and multiply it by 100 to make it a percentage: ($880/$6,500) × 100 = 13.5%.
Based on Bella’s calculation, she is currently operating her small business at a 13.5% profit margin. Profit margins do vary by industry, but her current profit margin is considered healthy on average.
Scenario 2: Daniel designs graphics
In this second scenario, we’ll look at how to calculate gross profit margin for services rendered instead of goods sold by considering what these calculations look like for a different type of business.
The calculation is essentially the same for both business owners, but the trick is determining what the COGS are in Daniel’s case. Suppose Daniel’s total sales for one month are $4,000. His COGS include the following:
- $500 for work subcontracted to another person
- $20 for paper and ink used in printing interactions of different designs
- $200 for poster board presentations of designs to clients
Daniel’s gross profit is: $4,000 – $500 – $20 – $200 = $3,280
His gross profit margin is: ($3,280/$4,000) × 100 = 82%
Knowing how to calculate the profit margin of your business is important if you are looking to make a profit and grow your business, whether you are looking to do so quickly or gradually.
While being a new business owner can be overwhelming, ZenBusiness can help you keep expanding your business vocabulary as you work toward growing your small business. Check out our resources and educational content at ZenBlog today.