What is profit margin?
Profit margin shows the profitability of a product, service, or business. It’s the percentage of revenue that’s left after all associated expenses have been deducted. The higher the percentage, the more profitable the business. Profit margin is the most essential financial ratio for monitoring the health of your business.
Two types of profit margin are most useful for business owners: Net profit margin, and gross profit margin. We’ll cover net margin first.
Say you’re running a coffee shop. You want to know what percentage of sales are left over after you’ve paid for all your expenses. These expenses include your direct costs (cost of goods sold), such as coffee beans and cups, as well as indirect costs such as your rent or taxes paid.
How to calculate net profit margin
In order to calculate your net profit margin, you’ll need your business’ net income, or net profit (this is the dollar amount left over after you’ve deducted expenses from gross income) and your total revenue, or total sales:
Profit margin ratio = Net Profit / Revenue
You can find your net profit and gross sales numbers on your income statement—one of the essential financial statements, along with the balance sheet and cash flow report.
We can make the profit margin calculation based on the income statement above:
$129,426.83 / $308,952.35 = 0.418, or 42%
This means that 42% of these sales are converted into profit—not too shabby!
How to calculate gross profit margin
Gross profit margin tells you the relationship between your revenue and your gross profit. In other words, gross margin is the portion of each dollar you keep after paying for the cost of making your product (Cost of Goods Sold, or COGS).
Gross profit margin ratio = Gross Profit / Revenue
If we apply this equation to the coffee shop example, we get a ratio of 76%, or $0.76 of every dollar that comes into the business.
Net profit margin vs. gross profit margin
While net profit margin and gross profit margin both show profitability, they’re doing so in different ways and shouldn’t be used interchangeably.
Net profit margin shows you how profitable your products, services, or business is after deducting both direct and indirect costs. In other words, net profit margin tells you how profitable your whole business is.
Gross profit margin shows you how profitable your products/services are after deducting only direct costs. That is, it tells you how well your pricing strategy is earning you money—but not how your internal operations affect profit.
Remember our coffee shop? If you want to know how much money you’re making per cup of coffee after you’ve deducted your direct costs, such as coffee beans and cups, you’ll use the gross profit margin calculation.
What gross profit margin doesn’t factor in? Any other operating expenses, such as the rent of your coffee shop or the software you use to run your till. In other words, net profit margin gives a broader picture of how your company is managing expenses relative to its net sales.
How to use profit margin in real life
You know how to calculate profit margin—but now what can you do with it?
If you have a healthy gross margin (say, 42% as in our earlier example), but your business is losing money, you know you need to cut costs. Your products are profitable, but your overhead is too high. You always need to look at net profit margin in connection with gross margin to understand if the problem is unprofitable products, or something else in the business.
But net profit margin isn’t just for your own benefit—it also gives people outside your company a clearer picture of your business’ financial health.
Investors and financial advisors like to compare profit margin year over year. Why? A healthy profit margin means that there’s enough profits to pay out dividends to shareholders. Similarly, a lender will be more likely to loan a business owner funds if they know they have a thriving business and the cash to pay them back.
Finally, low profit margins are an early warning sign for your finances. When profit margins dip, it means you’re incurring more expenses than you did before. A new cost is cutting into your bottom line, and you need to identify it in order to maintain cash flow and keep your business on track.