A business' profit
margin is a key piece of information about whether or not the business
is producing income, and if so, how much. You’ll need to monitor your
business' profit margin to create a good business plan, keep track of
your costs, adjust your prices, and measure the profitability of your
business is over time. Your profit margin is expressed as a percentage:
the higher the percentage, the more profitable your business is.
Part 1
Calculating Profit Margin
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1
Know the difference between gross profit , gross profit margin, and net profit.
Gross profit is your total revenue earned from your goods or services,
minus the cost of producing or providing those goods or services (COGS).
This calculation does not include expenses like payroll, rent, or
utilities; it only considers the cost directly related to creating those
goods and services.
[1] Gross profit margin is the gross profit divided by revenues.
- Net profit takes all business expenditures into account and is
calculated as gross profit minus administrative expenses and other
relevant expenses. This includes regular operational costs (payroll,
rent, etc.) and one-time costs (taxes, contractor invoices, etc.). You
must also include any additional earnings, such as investment income.[2]
- Net profit provides a more complete and detailed rendering of the
business health and is generally what is used to manage the business.
The steps below detail how to find this number.
- Net profit is also known as "the bottom line."
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2
Determine your calculation period. To calculate your
business's profit margin, choose the period of time you want to analyze.
Generally, people use either months, quarters, or years to calculate
their profit margins.
- Consider why you want to calculate your margins. If you are applying
for loans or looking to attract investors, these people will want to
know more than just how your business did over a single month. However,
if you're comparing your profit margin between different months for your
own purposes, it's fine to use shorter periods of time.
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3
Calculate the total revenue generated by your business during the calculation period. Revenue is everything the business brings in through sale of goods, services, or earnings of interest.
[3]
- If your business only sells goods, such a retail shop or restaurant,
your total revenue is all the sales you had during the period you've
chosen to analyze minus any returns or discounts. If you don't already
have this figure on hand, multiply the total number of items you sold by
the price of each of those items and then adjust for returns and
discounts.
- Similarly, if your business provides services, such as lawn mowing,
your total revenue is all of the amounts you collected for your services
during a period.
- Finally, if the business involves owning securities, you should
include the interest and dividend income from those sources in your
total revenue calculation.
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4
Subtract all your expenses to calculate your net income.
Expenses are the opposite of revenue. They're any amounts you have had
to pay, or will pay in the future for things you did and/or used during
the calculation period.
[4] This includes expenses incurred to operate as well as the expense required to carry investments.
- Common expenses are the cost of labor, rent, electricity, equipment,
supplies, inventory, banking, and interest expense on loans.[5] Generally if you run a small business you can just add up everything you paid for during the period.
- For example, if your business earned $100,000 in revenue during the
calculation period, and in order to earn that revenue the business spent
$70,000 on rent, supplies, equipment, taxes, and interest payments, you
subtract $70,000 from $100,000, your remaining revenue after expenses
was $30,000.
-
5
Divide your net income by the total revenue you already calculated. The resulting percentage is your profit margin, which is the percent of your revenue that you keep as income.
[6]
- In our example above, our difference was $30,000. $30,000 ÷ $100,000 = .3 (30%)
- As a further example, if your business sells paintings, the profit
margin calculation tells you on average, when a person pays for a
painting, how much of that money you will keep in profit.
Part 2
EditMaking Sense of Your Profit Margin
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1
Assess whether your profit margin meets your business needs.
If you plan to live solely off income from your business, consider your
profit margin and the amount of sales you generally make in a year. You
will want to reinvest some of your income into developing your
business, so when you take that amount out, is the remaining profit
enough to sustain your lifestyle?
- For example, like above, your business netted $30,000 in cash after
$100,000 in sales. If you use $15,000 of the profit to reinvest in your
business (and potentially pay off loans), you have $15,000 left over.
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2
Compare your profit margin to other similar businesses.
Another useful aspect of knowing your profit margin is comparing it to
similar businesses to determine where you stand. If you are applying for
a loan, the bank will likely tell you what kind of profit margin they
expect for your size and/or business type. If you are a larger company
with competitors, you can likely research those companies and learn
their profit margins to compare them to yours.
- Say that Company 1 has revenue of $500,000 and total expenses of $230,000. This would give it a profit margin of 54%.
- Assume that Company 2 has revenue of $1,000,000 and total expenses
of $580,000. This means that Company 2's profit margin is 42%.
- Company 1 has a better profit margin, even though Company 2 makes double of what Company 1 does and has a higher net profit.
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3
Compare apples with apples when comparing profit margins.
Companies have widely varied profit margins based on their size and
industry. It is best to compare two or more companies in the same
industry and with similar revenues in order to make the most of the
comparison.
- For example, the airline industry averages around only 3% profit
margins, while technology and software companies average in the 20%
margin range.[7][8]
- When comparing your company, also consider size to ensure your comparison is meaningful.
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4
Adjust your profit margin if necessary. You can
change your profit margin percentage by making more revenue (such as by
increasing the price of your products or selling more of them), or by
reducing the expenses associated with your business. Also, even if your
profit margin remains the same, if you increase your total revenue and
expenses, your net income will increase in dollar value. Consider your
business, competition, and risk tolerance as you experiment with raising
prices or cutting costs.
- Generally you should make small changes and work up to larger ones
to prevent a dive in business or angering your customers. Remember that
there is a cost to increasing your profit margin, and doing so too
aggressively can have the reverse effect by tanking your business.
- Don't confuse profit margins with markup. Markup is the difference
between what something costs to produce and how much it is sold for.
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