If you’re running a business or thinking of investing, you’ll want to know how to understand, calculate and analyze profit data.
In accounting and business finance, profit calculations can give different information about where costs and profits lie in a business. This allows companies to show how profitable one product is versus another, or how the costs associated with the day to day running of their business impact net earnings. This information is then used by business owners, investors and analysts to examine and improve the performance of a business.
Read this guide for all you need to know about different profit margin calculations, and their uses.
Profit margin definition
The different profit calculations used in business finance show gross profit margin, operating profit margin and net profit margin. Profit margin figures are always expressed as a percentage. You’ll also find absolute dollar figures for these profit measures on a company’s income statement.
Gross profit margin shows how much money a product makes, minus only the direct costs of producing that product. This is commonly used to compare one product against another.
A company’s operating profit margin is a slightly broader picture, showing the income of the business minus the total operating expenses. This is used to show the ability of a company to generate profit – but it doesn’t take into account some costs or potential income streams such as taxes and interest.
Net profit – also known as net earnings – is the final figure used to show the full impact of all income and expenses over the accounting period. This is also known as the bottom line.
How to calculate profit margin
The calculation method is slightly different depending on whether you’re trying to work out the gross profit, operating profit or net profit of a business. However, the basic model is similar for all:
Profit margin = ((sales – expenses) ÷ revenue) x 100
Gross profit margin
If you’re looking to work out gross profit margin you’ll need to compare the profit made by different goods or services once variable costs are removed. This allows you to see how much profit a particular product in your range makes, compared to another.
Variable costs in this case are also known as cost of goods sold – COGS. COGS includes the direct costs of materials for your product, and the labor costs to produce it for example. Here’s the formula used:
Gross profit margin = (gross profit ÷ net sales) x 100
If you don’t already know your gross profit for a particular product line, you can calculate it by taking the total revenue for the product, minus the cost of goods.
Operating profit margin
Gross profit margin is a good way to compare the direct profit from one specific product to another. However, it doesn’t include other costs involved with operating a business and selling goods, such as marketing and administrative costs. If you want to represent these costs, you’ll need to calculate your operating profit margin instead.
Here’s the formula for operating profit margin:
Operating profit margin = (operating profit ÷ net sales) x 100
Operating profit is used to show how much profit your business is making without the impact of taxes or interest. The figure may be similar to your company’s EBIT (Earnings before interest and tax – read more about EBIT and EBITDA, here).
Net profit margin
The final calculation you might use is to get your net profit margin. Net profit is also known as net income – or the bottom line. It’s called this because this calculation is always shown on the bottom line of a company’s income statement, and looks at the profitability of a company after all income and expenses have been factored in.
Here’s the net profit margin calculation:
Net profit margin = (net profit ÷ net sales) x 100
Net profit is the final figure produced, which shows the impact of all transactions over the accounting period, whether these are regular sales and costs, one off payments or credits, taxes and so on. This makes it a useful number for investors and analysts who want to see how much money the business is making for shareholders, or how much is left to reinvest.
What is a good profit margin?
Naturally, once you’ve worked out your profit margin you’ll want to know if it’s good, bad or indifferent. However, there are a number of things to consider when trying to assess your profit margin.
A good net profit margin varies widely by industry, and can also be impacted by your location, and whether you’re running a new or established business. Looking for average net profit information for your own industry or location is the best way to get a sense for performance against this metric.
It’s also worth knowing that newer businesses tend to have a higher net profit margin than more established, larger companies. That’s because larger businesses need to hire more people, which drives up the complexity of the operation and can push down overall net profit margin levels.
Net vs gross profit
You can find information about gross profit and net profit on a company’s income statement. Gross profit comes closer to the top of the income statement while net profit is shown right at the bottom – the bottom line.
Both figures are useful in their own way, but it’s important to realise they’re very different calculations. Gross profit looks at income minus the cost of goods sold, but does not include any of the operating costs of the business, or other inevitable expenses like taxes. Net profit on the other hand includes all the income and expenses incurred by a company over the accounting period.
Gross margin vs gross profit
Gross margin and gross profit show similar information, but expressed in a different way. When you calculate a margin, you’re looking to show a percentage. However, gross profit is an absolute dollar figure for the amount of profit.Here you can see how the 2 calculations relate to each other:
Gross profit = total revenue – cost of goods sold
Gross margin = ((total revenue – cost of goods sold)/ total revenue) x 100
No matter what type of business you run, you’ll want to understand how to analyze and improve your profits. Use the basic calculations in this guide as a starting point, so you can strengthen and grow your company.