Small business owners often confuse profit margin and markup. Both of these metrics help a business set prices and measure profitability, but it’s important to know the difference—and know how to calculate the two numbers.
How to calculate profit margin
Gross margin shows the revenue a company has left over after paying all the direct expenses of manufacturing a product or providing a service. Those direct costs are also called cost of goods sold (COGS).
The gross profit margin formula is:
Gross Profit Margin = Gross Profit / Revenue
For example, consider the following income statement for Chelsea’s Coffee & Croissants, a fictional coffee shop and bakery:
Chelsea’s Coffee & Croissants
Income Statement
For the Year Ended December 31, 2020
Description | Amount |
---|---|
Revenues: | |
Coffee sales revenues | $35,000 |
Pastries sales revenues | 20,000 |
Total Revenues | 55,000 |
Cost of Sales | |
Cost of Goods Sold | 15,000 |
Gross Profit | 40,000 |
Operating Expenses | |
Salaries | 15,000 |
Rent Expense | 10,000 |
Utilities Expense | 2,500 |
Net Income (Loss) | $12,500 |
Using the income statement above, Chelsea would calculate her gross profit margin as follows:
$40,000 / $55,000 = .73
In other words, for every dollar of revenue, the business makes $0.73 after paying for COGS.
How to calculate net profit margin
Net profit margin is similar to gross profit margin, but instead of just considering COGS as a percentage of revenue, it includes all expenses in the formula, including operating expenses such as rent and utilities in addition to COGS.
The formula for calculating net profit margin is:
Net Profit Margin = Net Profit / Revenue
Using the income statement above, Chelsea would calculate her net profit margin as:
$12,500 / $55,000 = .23
In other words, for every dollar of revenue the business brings in, it keeps $0.23 after accounting for all expenses.
Calculating profit margin as a percentage
Both gross profit margin and net profit margin can be expressed as a percentage. You do this by multiplying the result by 100. For example, Chelsea’s Coffee and Croissants has a gross profit margin ratio of 73% and a net profit margin ratio of 23%.
Whether you express profit margin as a dollar amount or a percentage, it’s an indicator of the company’s financial health. These metrics help investors and lenders compare your company to others in the same industry. They also show how well the business is pricing its products and managing costs.
Markup definition (and how to calculate it)
Markup is different from margin. Markup shows how much higher your selling price is than the amount it costs you to purchase or create the product or service.
So, the formula for calculating markup is:
Markup = Gross Profit / COGS
Usually, markup is calculated on a per-product basis. For example, say Chelsea sells a cup of coffee for $3.00, and between the cost of the beans, cups, and direct labor, it costs Chelsea $0.50 to produce each cup.
Chelsea could calculate her markup on a cup of coffee as:
$3 / $1.25 = 2.4
Or, expressed as a percentage, her markup would be 240%. Typical markup can vary greatly between industries. For example, in a grocery store, staples like bread and milk might have a markup of only 5 – 8%. But for coffee shops, a markup of 300% is normal, so Chelsea actually prices her coffee fairly reasonably.
Bottom line
Margin and markup are like two sides of the same coin—they describe the same thing but from different perspectives. Margin shows the relationship between profits and revenues, which markup shows the relationship between profit and cost of goods sold. Knowing the difference can help you price your products and services correctly and set profit goals