Profit margin shows what percentage of your revenue comprises profit, as opposed to business costs and expenses. In other words, profit margin tells you how much you make on the sale of each product or service. Profit margin goes to the heart of whether your business is doing well.
When it comes to managing your business finances, understanding your profit margin is a crucial component. While it seems logical, there are many things small business owners either don’t know or forget about profit margins—including what their margin goals should be to begin with.
In this guide, we’ll define what profit margin is, as well as explain how to use the profit margin formula to calculate this number for your business. Let’s get started.
There are two types of profit margins that small businesses can measure:
Note that net profit takes all business expenses into account, not just the cost of goods. Your net profit margin helps you determine how efficient your business is at converting profits from sales, while your gross profit margin helps you figure out the profitability of a specific product or service.
The profit margin formula is net income divided by net sales. To calculate the profit margin of a business, most organizations use the following formula:
Profit Margin = (Net Income/Net Sales) x 100
To calculate gross profit, you’ll need to subtract the cost of goods sold (COGS) from revenue. You can use the formula below to calculate gross profit:
Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue x 100
A strong gross profit margin means that your business is generating more profits over your costs.
Now that you’re aware of the net profit and gross profit margin formulas, let’s go into further details about the formula components:
It’s important to remember that to get an accurate look at what your small business’s profit margin is, you need to look at all the details. Keep track of everything: from expenses like payroll, utilities, and shipping to every source of revenue, including the small stuff like transaction fees or maintenance contracts. This gives you a very clear picture of your company’s margins, so you have to be extra careful not to miscalculate or leave anything off the books. A great online tool to help you determine your margins is OmniCalculator.
The numbers that you need to calculate your profit margin will also show up on your latest profit and loss statement. If you need to update your income statement, you should be able to do so quickly with business accounting software.
Here’s how to calculate profit margins using the following example:
Let’s say you run an ecommerce business, ABC Ecommerce. In 2019, ABC Ecommerce generated $800,000 in annual revenue. Your net income was $250,000. Your cost of goods is $300,000.
To calculate your profit margin, you first need to calculate your net income and net sales. Once you’ve identified your net income and net sales, you can use the profit margin formula.
Here’s how to calculate ABC Ecommerce’s profit margin:
ABC Ecommerce’s Profit Margin = ($250,000/$800,000) x 100 = 31.25%
To calculate ABC Ecommerce’s gross profit, you’ll need to know revenue and COGS.
ABC Ecommerce’s Gross Profit Margin = ($800,000 – $300,000) / $800,000 x 100 = 62.5%
In summary, ABC Ecommerce’s profit margin is 31.25%, and its gross profit margin is 62.5%.
Although there are slight variations on the definition, a profit margin typically represents the percent of revenue earned after all costs, business taxes, depreciation, interests, and other expenses have been deducted.
These are some reasons you should track your profit margins:
Once you have your profit margin, you can see how many revenue dollars are actually going to your bottom line, as opposed to covering your business expenses. This valuable metric can also reveal whether you’ve priced your product too high or too low.
A good profit margin very much depends on your industry and expansion goals and a host of other factors, like the economy. It can sometimes seem like comparing apples to oranges.
Industries with hardly any overhead costs, like consulting, for example, have higher profit margins than, say, a restaurant, which pays overhead costs in facilities, payroll, inventory, and so on. S&P 500 reports the blended net profit margin for Q1 2018 to be 11.6%. Profit margins above 11% outperform those of the market, but a margin under 15% to 20% indicates vulnerability to negative market changes. Again, it’s hard to compare every small business against this average as all businesses are unique and operate differently.
See some factors that affect what makes a “good” profit margin below:
More example industry margins from the NYU study:
Of course, knowing what is a good profit margin and understanding your margins is the first step in improving your margins. Once you have that data, these are just a few ways you can help your business improve its profit margin:
A high profit margin means that a business is highly profitable and running efficiently.
No. Gross margin is a percentage of a business’s revenue, while gross profit is the amount you get after you subtract the cost of goods sold (COGS) from revenue.
Gross profit margin indicates the profitability of a business and is a measure of a business’s financial health. A good profit margin means a business is very profitable.
Profit margins can be tricky—both determining them and understanding what’s right for your business. Do your research for your industry and make sure to track those numbers down to every last expenditure and revenue source. Knowing where you are with your profit margin helps you determine where to go next, and it’s different for every business.
Meredith Wood is the founding editor of the Fundera Ledger and a vice president at Fundera.
Meredith launched the Fundera Ledger in 2014. She has specialized in financial advice for small business owners for almost a decade. Meredith is frequently sought out for her expertise in small business lending and financial management.