You keep hearing here and there that you’re supposed to increase your profit margins, but… What is profit margin? In this article, we’ll explain it to you and show you how to calculate the profit margin for your business.
What is profit margin?
Profit margin is a financial term that shows how much money a company makes after paying for all the things it needs to run the business. It’s like the amount of money you have left over after you pay for all your bills and expenses.
For example, imagine you run a bakery and you sell cakes for $20 each. However, each cake costs you $10 to make (for ingredients, labor, and other costs). So, when you sell a cake for $20, you have a profit of $10.
So, for each cake you sell, you make a profit of $10. That means your profit margin is 50%. You can use this money to buy more supplies, save for the future or spend on whatever you want.
In the same way, businesses use profit margins to measure how much money they make after paying for all their expenses. It’s an important way to see if a business is doing well or not. A high profit margin means the business is making a good amount of money, while a low profit margin means the business may be struggling to make a profit.
There are several types of profit margins, including gross profit margin, operating profit margin, and net profit margin. We’ll explain each one of them to you.
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What is gross profit margin?
Gross profit margin is how much money you have left after subtracting the cost of making or buying your products. It's a way to measure how much money is left over after you’ve paid for the costs of producing the goods sold.
Let’s get back to the bakery example. Your gross profit margin is the percentage of profit you make from each cake, compared to the total amount you sold the cake for. If you sold 100 cakes for $20, and each cake had a profit of $10, your total profit would be $1,000 and your gross profit margin would be 50%.
High gross profit margins are usually a good thing, because it means the company is making a good profit from its products. However, a low gross margin may mean the company is selling its products for too little, or that the cost of producing them is too high.
What is operating profit margin?
Operating profit margin is a financial metric that shows how much money a company is earning from its core business activities after deducting all of its operating expenses.
So, you sell cakes for $20 each. You have to pay for ingredients, labor and cost of goods sold, which totals $10 per cake. You also have to pay for other expenses to run your bakery, from rent to email marketing. Let's say those expenses total $6,000 per month.
If you sell 200 cakes per month, your revenue would be $4,000 (200 cakes x $20 per cake). Your total operating expenses would be $6,000. So, your operating income would be $4,000 - $6,000 = -$2,000.
In this case, your bakery is not making a profit from its core business activities. You would need to either increase your revenue, decrease your operating expenses or find ways to improve your efficiency to improve your operating profit margin.
On the other hand, if your revenue was $10,000 per month and your operating expenses were still $6,000, your operating profit would be $4,000. In this case, your operating profit margin would be 40%, which is a healthy margin for a bakery. This means you’re generating a good profit from your core business activities after paying for your operating expenses.
What is net profit margin?
Net profit margin is a financial term that shows how much profit a company makes after subtracting all of its expenses, including both operating and non-operating expenses. We use the company’s net income to measure the overall profitability of the business.
Let's continue with the example of the bakery. Suppose that the bakery generates $10,000 in revenue per month from selling cakes, and has $8,000 in expenses per month, including operating expenses like rent, salaries, and utilities, as well as non-operating expenses like taxes, interest payments and depreciation of equipment.
To calculate the net profit margin, we need to subtract all expenses from the total revenue. In this case, the net profit would be:
$10,000 (total revenue) - $8,000 (total expenses) = $2,000
So, the bakery has a net income of $2,000 per month.
To calculate the net profit margin, we divide the net profit by the total revenue and express the result as a percentage. In this case, the net profit margin would be:
$2,000 (net profit) / $10,000 (total revenue) x 100% = 20%
So, the bakery has a net profit margin of 20%.
In other words, for every dollar of revenue generated, the bakery earns 20 cents of net sales or revenue. This represents the overall profitability of the bakery, taking into account all of its expenses, both operating and non-operating.
A high net profit margin is generally a positive sign, as it means the company is earning a healthy profit after all expenses are accounted for. A low net profit margin, on the other hand, may indicate that the company is struggling to generate a profit and may need to make changes to its operations or pricing strategy to improve profitability.
Why is profit margin important?
Profit margin is an important metric for several reasons. First, it indicates how efficiently a company is using its resources to generate profits. High profit margins (particularly a net profit margin) indicates that a company is generating significant profits relative to its sales revenue, while low profit margins suggest that the company may be struggling to generate profits.
Different types of profit margins can be used to evaluate different aspects of a business:
- Gross profit margins are used to evaluate the efficiency of the production process.
- Operating profit margins are used to evaluate the profitability of the core business activities.
- Net profit margins help businesses evaluate the overall profitability of the business.
Second, profit margin is a useful tool for comparing the financial performance of different companies. For example, two companies may have the same revenue, but one may have a higher profit margin than the other, indicating that it’s generating more profits relative to its revenue.
Third, profit margin is an important factor for investors to consider when evaluating the financial health and profitability of a company. A company with a high profit margin is generally considered to be a more attractive investment opportunity than a company with a low profit margin.
How to calculate profit margin
Calculating profit margin is relatively straightforward. The profit margin formula is:
Profit margin = (net profit ÷ revenue) x 100
To calculate profit margin, you first need to determine the net profit and revenue of the company. Net profit, is the profit that remains after all expenses have been deducted. Revenue is the total amount of money earned by the company from sales.
Once you have determined the net profit and revenue, you can use the formula to calculate the profit margin. For example, if a company earns $1,000,000 in revenue and has a net profit of $200,000, the profit margin would be:
Profit margin = ($200,000 ÷ $1,000,000) x 100 = 20%
This means that the company earns 20% of its revenue as profit.
What is a good profit margin?
Now you might be wondering, what is a good profit margin for your business?
A good or healthy profit margin for a business can vary depending on the industry and the size of the company. Generally, a higher profit margin indicates that the business is generating more profit per dollar of revenue, which is a positive sign. However, what is considered a good profit margin can depend on various factors such as industry norms, the stage of business development or the company’s strategic goals.
As a rough guideline, a profit margin of around 10% is considered healthy for most businesses. This means that for every dollar in revenue, the company earns 10 cents of profit. However, profit margins can vary significantly depending on the industry. For example, a grocery store might have a profit margin of only 2-3%, while a software company might have a profit margin of 20-30%.
What is profit margin: conclusion
Profit margin is a crucial financial metric that indicates how efficiently your company is generating profits relative to its revenue. There are several types of profit margins, including gross profit margin, operating profit margin and net profit margin. Calculating profit margin is relatively straightforward, and it’s a super important tool for evaluating the financial health and profitability of your company.