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.
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 profit margin
In order to calculate your 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 sales, or revenue:
Profit margin ratio = Net Profit / Revenue
We can make the profit margin calculation based on the income statement above:
= 0.418, or 42%
This means that 42% of these sales are converted into profit—not too shabby!
Profit margin vs. gross margin
While profit margin and gross margin both show profitability, they’re doing so in different ways and shouldn’t be used interchangeably.
Profit margin shows you how profitable your products, services, or business is after deducting both direct and indirect costs. In other words, profit margin it tells you how profitable your whole business is.
Gross margin shows you how profitable your products/services are after deducting only direct costs. In other words, it tells you how profitable your products/services are, but not necessarily your business as a whole.
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 margin calculation.
What gross 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, 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 profit margin in connection with gross margin to understand if the problem is unprofitable products, or something else in the business.
But 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 your business funds if they know you have a thriving business and the cash to pay them back.