How to Calculate Profit Margin

Author

Kevin Urrutia

Category

Marketing

Posted

January 27, 2023

The profit margin of any business is an essential barometer of its health and potential longevity. In addition, knowing your business’s profit margin allows you to make informed decisions regarding its future and goals.

Defining Profit Margin

One of the most critical indicators of a successful business is its profit margin. You need to understand what is meant when the phrase “profit margin” is mentioned.

In its simplest terms, your profit margin is a metric that indicates how much money a business is making. It measures how effectively the company uses its earnings to pay its expenses.

The profit margin of a business is a reflection of the revenue percentage that your company retains. You can determine the profitability of your business for a specific time frame by knowing how to calculate its profit margin.

Even though some business owners think that profit margin is the same as net profit, the two financial terms have different definitions. While yield is expressed as a dollar amount after subtracting all your business expenses from its earnings, it is not a percentage.

Helpful Definitions to Know

Some business terms are so closely related that teasing out their differences is necessary to obtain clarity.

  • Margin: this term applies to the markup you tack on to every product or service your business offers so that a profit is made with each sale.
  • Cost is the bottom line amount that your business takes to produce a service or product. It considers the cost of materials and labor and variable costs. It knows the price and assists you in planning your profits.
  • Revenue: when the profit and cost are combined, the result is revenue. It is the final amount a customer pays for a particular product or service. Use this figure to help you determine the success of each of your offerings.
  • Profit: by subtracting your costs from your business’s revenue, you arrive at your profit. You must know the profit your business accepts. Additionally, to fuel growth, your business must see a consistent increase in profits.

Net and Gross Proft Margins: Both are Valuable to Know

The profit margin of a business can be categorized as either gross or net. Both metrics are valuable to know because they let you examine profitability in different ways.

As a measurement, the gross profit margin helps you determine how good a single service or product is for your business. Once it’s calculated, you’ll discover which items are better than others.

When a business’s profitability is discussed, its net profit margin is usually meant. To determine the profitability of your business as a whole, however, you need to decide on its net profit margin. This measurement compares your business’s expenses and total earnings.

How to Calculate Profit Margin

The formula to correctly calculate your business’s profit margin is simple. This makes it a convenient tool for staying informed about your finances.

It consists of a three-step process. First, you’ll need to find the net income for your business. This is obtained by subtracting its total expenses from its revenues.

Next, you must divide your net income by the business’s revenue. Lastly, multiply that number by 100, leaving you with a percentage.

Real-Life Example

Understanding your business’s profit margin is essential to ensuring that it grows, moves forward, and meets goals. Knowing the profit margin is also beneficial if you want to secure a business loan or engage in a similar financial transaction.

Suppose your business wants additional capital to expand in a particular area. Gathering crucial data to present to potential investors gives them a picture of the business’s health. This example uses round numbers for illustration purposes.

Calculate Gross Profit

Using your business’s income statement is an excellent place to start. If your company has revenue of $100,000, but the cost of the products or services sold is $38,000, that leaves it with a gross profit of $62,000. Next

Determine Total Expenses

For this example, your payroll — which is your business’s most significant expense other than the cost of the products or services provided — is ,000. Insurance is $8,000, rent comes to $6,000, and miscellaneous supplies run about $1,000. This means the total expenses for your business are $37,000.

Calculate Your Net Income

To calculate your business’s net income, subtract its total expenses from its revenue. Remember that this figure includes not only the operating costs for the business (,000 in the example) and the cost of the products or services you sell (,000 in the example).

Your business has $75,000 in total expenses (operating costs plus the cost of goods). Since your revenue is $100,000, your net income is $25,000.

Next, you’ll need to divide your business’s net income by its revenue. This means that $25,000 in net income is divided by $100,000 in revenue, which equals 0.25.

Finally, multiply that number by 100 to get a percentage result. 0.25 multiplied by 100 equals 25 percent. This means that after your business pays out for its expenses, it keeps 25 percent of its earnings.

Using Profit Margin Data

In addition to showing potential investors that your business is generating a profit, finding out the profit margin is also helpful in determining how it uses the money it brings in. The profit margin that is standard for a business depends heavily on the industry that it’s in. It’s also important to remember that the average profit margin for a particular sector can range by several percentage points.

Staying on top of your profit margin gives you the tools to make an informed decision should you discover that your business is not as profitable as you would like. You’ll be able to examine the different categories of expenses and costs to determine if there are ways of boosting sales or reducing expenditures.

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