Profit margin is one of the easiest and most commonly used financial ratios in corporate finance. You can find a company’s profit calculated at three levels on its income statement, each with its own profit margin. To find these margins, you divide the profit by the revenue and then multiply by 100.
The simplest measure is gross profit, while the most detailed one is net profit. In between these two is operating profit.
Types of Profit Margins
The gross profit margin, operating profit margin, and net profit margin are the three different forms of profit margins. Each one gives you a glimpse into how well a company is doing financially.
Gross Profit Margin
Gross profit is the simplest measure of profitability. It shows how much money a company makes after subtracting the cost of goods sold (COGS). COGS includes expenses directly tied to producing items for sale, like raw materials and labor costs.
However, it doesn’t include things like debt payments, taxes, overhead costs, or one-time expenses like buying equipment. The gross profit margin compares gross profit to total revenue, showing what percentage of each revenue dollar is kept as profit after covering production costs.
This formula can be used to get the gross profit margin:
GPM=Net sales−COGS/Net sales×100
Operating Profit Margin
Operating profit is a bit more complex. It considers all the overhead, administrative, and sales expenses needed to keep the business running day-to-day. While it still doesn’t include debt and taxes, it does factor in the depreciation of assets.
By dividing operating profit by revenue, this margin tells you what percentage of each dollar remains after covering all necessary operating expenses.
The formula for operating profit margin is:
OPM=Operating Income/Revenue×100
Net Profit Margin
The net profit margin shows how well a company turns its income into profit. Known as the “bottom line,” net income represents the total revenue left after accounting for all expenses and additional income sources. This includes COGS, operational expenses, debt payments, taxes, one-time costs, and income from investments.
You can calculate the net profit margin using either of these formulas:
NPM=(R−CGS−OPE−OTE−I−T/R)×100
or
NPM=(Net income/R)×100
Where:
- NPM = Net profit margin
- R = Revenue
- CGS = Cost of goods sold
- OPE = Operating expenses
- OTE = Other expenses
- I = Interest
- T = Taxes
These profit margins help you understand how efficiently a company is operating and how much profit it keeps from its revenue.
What Is a Good Profit Margin?
It really depends on the company and the industry. Profit margins can vary widely between different sectors, so you can’t really compare a retail company’s margins to those of an oil and gas company, for example.
That said, you can use profit margins to get a sense of how well a business is doing. A profit margin of 20% is a sign that the company is making good profits, while 10% is considered average. If a company has a profit margin of 5% or lower, it might be facing some issues.
Some studies have looked at profit margins across various industries. For instance, research from New York University found net profit margins that range from about -29% to as high as 33%. The hotel and gaming industry had an average net profit margin of -28.56%, while banks showed a much healthier average of 32.61%.
No matter where a company stands, it’s crucial for business owners to keep an eye on their competitors and their own profit margins to ensure they’re in a strong position.
How to Calculate Profit Margin in Excel
Calculating your gross profit margin can be a lot easier with software like Microsoft Excel. Using spreadsheets helps simplify the process. Before you start, gather some basic information, like your revenue and cost of goods sold (COGS).
Here’s how to set it up easily:
- In the first column (Column A), enter your revenue figures.
- In the second column (Column B), input your COGS.
- In Column C, calculate your overall profit. If your revenue is in cell A2 and your COGS is in B2, then C2 will be the difference between A2 and B2.
- For the profit margin, use Column D. Enter this formula: ((C2/A2) \times 100).
Here’s a simple example to illustrate how it works:
| A | B | C | D |
|---|---|---|---|
| REVENUE | COGS | PROFIT | PROFIT MARGIN |
| $100 | $40 | $60 | 60% |
| $300 | $75 | $225 | 75% |
This table gives you a clear idea of how to calculate profit margins easily in Excel!
Example of Profit Margin
For the fiscal year ending on October 3, 2021, Starbucks (SBUX) reported a revenue of $29.06 billion. Their gross profit was $20.32 billion, and the operating profit came in at $4.87 billion. In total, Starbucks made a net profit of $4.2 billion.
Here’s how you can calculate their profit margins:
- Gross profit margin: ($20.32 billion ÷ $29.06 billion) × 100 = 69.92%
- Operating profit margin: ($4.87 billion ÷ $29.06 billion) × 100 = 16.76%
- Net profit margin: ($4.2 billion ÷ $29.06 billion) × 100 = 14.45%
This example shows how important it is for a company to have strong gross and operating profit margins. If these margins are weak, it means the company is losing money on its basic operations, which leaves less revenue to pay off debts and taxes. Luckily for Starbucks, their solid gross and operating profit margins allowed them to enjoy decent profits while still covering all their financial responsibilities.
How to Improve Your Profit Margin
If you’re a business owner, improving your profit margin is key to growing your company. Your profit margin tells you how much money you keep from every dollar of gross revenue. When you boost your profit margin, you can actually make more money without needing to increase your sales or overall revenue.
Track Income and Expenses
Hopefully, you’re already keeping an eye on your profits. But to truly improve your profit margins, you also need to know how much you’re spending. Every expense eats into your profit margin. While some costs, like supplies, website hosting, and employee salaries, are necessary, tracking your expenses can help you spot unnecessary costs that you can cut to boost your profit margin.
Buy in Bulk
Does your business frequently buy the same supplies? Whether they’re for daily operations, making products, or shipping to customers, try not to just purchase them as needed. Keep an eye on prices and buy in bulk when they’re low or on sale. Buying in bulk usually means you’ll pay less per item, which cuts your expenses and increases your profit on each sale.
Increase Efficiency
Are there parts of your business that you could automate? No matter what type of business you run, taking too long can cost you more money. Look for software that can help you collect and organize customer information or manage shipping data and notifications. By automating some tasks or finding ways to work more efficiently, you can save time and money, allowing you to make more sales without extra effort and boosting your profit margin on each sale.
Prioritize Customer Retention
Finding new customers can be time-consuming and expensive. Instead, focus on keeping your current customers happy so they keep buying from you. You can use automated emails or even personal messages to follow up with new customers. Offer discounts for repeat purchases and show your appreciation through social media or a rewards program. When you lower your marketing costs for each sale, your profit from those sales will increase, which means a higher profit margin.
Also Read: How to Use QuickBooks for Small Business?
Know What Sells
You probably have a good idea of which products your customers love. If there’s something that isn’t selling well, spending time and money on it won’t help your profits. Many businesses regularly cut low-performing products or services. If something is popular, keep it around. But getting rid of items that aren’t selling will lower your costs and boost your sales, which will raise your profit margin too.
