Profit Margin: What It Is and How to Calculate
Profit margin measures how much profit you keep after subtracting business expenses. Shown as a percentage, profit margins are used to track performance trends, attract investors and sustain long-term growth.
Understanding how to calculate and improve your profit margin can help you make more informed decisions to keep your business on the road to success.
- Profit margins are a key indicator of a business’s financial health, measuring performance, profitability and the potential for growth.
- Margins can be expressed as gross profit (profitability of a company’s products), operating profit (profitability after deducting cost of goods and operating expenses) or net profit (the “bottom line” after accounting for all expenses, including taxes and interest).
- Profit margins vary significantly by industry, so it’s important to compare against industry averages and competitors to assess your business’s performance.
What is profit margin?
Profit margin is a common way to describe the amount of revenue a company keeps after deducting the cost of goods and all business expenses. While a company’s “profits” are expressed in dollar amounts, “profit margins” are typically shown as a percentage — if a company has a 10% profit margin, it means their final profit is 10 cents per every dollar of revenue.
A business with a high profit margin typically indicates robust financial health, effective management and a high potential for growth. Depending on the industry, having a high profit margin may attract investors.
To calculate profit margin, you’ll need to know the following items, which are included on your income statement:
- Revenue: The dollar amount of your sales of products or services.
- Cost of goods sold (COGS): The direct material and labor cost of producing these products and services.
- Gross profit: Revenue minus COGS.
- Overhead expense: Also called fixed or indirect cost, this includes all the expenses of your business operation other than what goes directly into your products. Examples include office rent, insurance, salaries, loan interest and employee benefits.
- Operating profit: Gross profit minus overhead expense.
- Net profit: Also called net income or the bottom line, this equals operating profit minus interest expense (on loans) and income taxes.
Profit margin and markup are often confused since both analyze how the price of a product compares to its cost of goods sold (COGS). However, they’re calculated in different ways — profit margin compares profit to revenues, while markup compares profit to COGS.
Say you manufacture a product with $25 COGS and sell it for $100. Your gross profit margin calculation is:
$100 revenue – $25 COGS = $75 gross profit
$75 Gross profit $100 revenue = 0.75, or 75% gross profit margin
But your markup equals three times your COGS — which means your markup is a lot higher than your profit margin, even though they’re describing the same product with the same cost.
$75 gross profit $25 COGS = 3.00, or 300% “markup”
Types of profit margin
There are three main types of profit margin, which are shown on a profit and loss statement: gross profit, operating profit and net profit. You can apply the same profit margin formula (profit divided by revenue) to each of these.
1. Gross profit margin
Gross margin is a simple calculation of your earnings for selling an item, minus the cost of producing that item. This metric shows the profit margin of a singular product or service, but does not indicate how the company is performing overall. A negative gross profit margin means you’re losing money on every sale and must adjust prices or cut costs to avoid going out of business.
Gross profit margin formula: Gross profit revenue = gross profit margin
Example: If it costs $40 to produce a leather purse and you sell it for $50 at your store, your gross profit is $10. Next, you divide the $10 by $50, which gives you a gross profit margin of 20%.
Gross profit margin can help assess your company’s profitability and efficiency at a particular moment. If you have a low gross profit margin, you may need to increase prices or find a more cost-effective way to produce your products or services.
Adjusted gross margin
Businesses storing inventories on sight, such as materials or finished goods, may benefit from calculating an adjusted gross margin to estimate the cost of inventory storage space, inventory losses due to obsolescence, theft and spoilage and the cost of financing related to the money tied up in inventory.
While adjusted gross margin follows the same calculation (revenue – cost of goods sold) as your gross margin, it then deducts any expenses related to storing and maintaining inventory.
Note that calculating your company’s adjusted gross profit margin requires complex analysis specific to your business. Working with an accountant can help you navigate the process.
Adjusted gross margin formula: Gross profit – (all the direct and indirect costs of holding inventory) revenue = adjusted gross margin
Example: If your shoe store earns $100,000 from sales and spends $70,000 on shoe production costs, your gross profit margin is 30%. But if you account for $3,000 for expenses associated with storing and maintaining inventory, such as warehousing, insurance and transportation, your adjusted gross margin is 27%
2. Operating profit margin
The operating profit margin takes your gross profit (see above), then subtracts your recurring operating expenses, such as administrative costs, marketing, bookkeeping services, salaries, office rent and utilities. The final percentage indicates how much revenue remains after covering these costs.
Note that nonrecurring expenses like selling old equipment, investment gains or losses, taxes or interest are generally not included in the operating profit margin.
Operating margin formula: Total revenue – (cost of goods sold + operating expenses) revenue = operating profit margin
Example: Let’s say your toy store earns $10 million in sales and spends $3 million on cost of goods and $2 million on recurring operational expenses. If you take the $5 million operating profit and divide it by the $10 million revenue, you’ll get an operating profit margin of 50%.
Operating profit margin can help a company understand its level of sustainability and scalability over the long term. If operating profit margin is low, you may need to focus on boosting efficiency before expanding to ensure you don’t spread yourself too thin.
3. Net profit margin
Often referred to as “the bottom line,” the net profit margin is a company’s total revenue after deducting all cost of goods sold, operating expenses, plus business taxes, interest and dividends paid to shareholders. Lenders typically require businesses to have a high net profit margin before considering a business loan application.
Net profit margin formula: Operating profit – (taxes + interest + dividends) revenue = net profit margin
Example: If your resort brings in a total of $10 million but spends $5 million in operating expenses, plus $1 million in additional costs (e.g., taxes, interest, dividends), your net profit is $4 million. To find your net profit margin, divide $4 million (net profit) by $10 million (total revenue) = 40%.
Net profit margin is an essential metric for measuring your company’s overall financial health. A high net profit margin indicates a company is thriving and turning a profit, while a negative net profit means your expenses exceed your revenue.
What’s a good profit margin?
There isn’t an official “good” profit margin, especially since it varies widely from industry to industry. For instance, a retail company’s ideal profit margin will differ greatly from an auto parts company.
That said, there’s an approximate scale that can indicate how your company is doing. In general, finance experts say a 5% net profit margin is considered “low,” a 10% net profit margin is “average” and a 20% net profit margin is “good.”
Comparing your company’s profit margin to other businesses within the same industry can give you an idea of how well your business is performing. Keep in mind that it’s expected for profit margins to be low during the early stages of establishing your company, due to startup expenses.
Here’s a look at how average profit margins stack up by industry.
| Industry | Average gross profit margin | Average net profit margin |
|---|---|---|
| Advertising | 28.11% | 0.89% |
| Auto Parts | 15.01% | 1.62% |
| Computer services | 25.52% | 4.40% |
| Electrical equipment | 32.52% | 15.22% |
| Publishing & newspapers | 45.99% | 1.82% |
| Real estate (development) | 32.20% | -16.35% |
| Restaurant/Dining | 32.43% | 10.66% |
| Retail (general) | 30.86% | 3.09% |
| Software (Internet) | 59.11% | -14.32% |
| Tobacco | 61.25% | 27.52% |
Data sourced from NYU Stern
How to increase profit margin
Since profit equals revenue minus expenses, the simplest way to improve your profit margin is to increase revenue and reduce expenses.
Here are some specific approaches to consider:
- Raising prices will increase revenue as long as you don’t make prices higher than your customers or clients are willing to pay.
- Reaching more customers through advertising or expanded hours of operation will increase revenue — but you’ll need to keep an eye on how much you spend to make sure your outreach costs aren’t higher than the new revenue you bring in.
- Encouraging larger purchases by selling accessories or warranty plans can increase revenue, although these items can also add to your costs.
- Sourcing lower cost materials suppliers will reduce your COGS.
- Keeping less inventory on hand may reduce storage costs or inventory financing expenses.
- Automating your operations will reduce labor costs once you’ve completed the upfront investment in equipment, software and training.
- Getting competitive bids in big spending categories like business insurance and web design can significantly reduce your fixed costs.
- Cutting back on nonessential expenses like travel and perks will also increase your operating profit.
- Paying off or refinancing a loan will cut down your interest expense and increase your net profit.
Next steps if your profit margin is stuck
It’s important to remember profit margins flex and change over time. You might have a highly profitable year, followed by a year with a negative profit margin. However, if you’ve tried all the above steps and your profit margin won’t budge, here are some more steps to take.
Decide whether your existing profit margins are a problem
For most businesses, profit margin can’t increase infinitely. If your business is in constant demand with high customer retention and a good profit margin that has seen steady growth, you may be near your current cap for how high your profit margin can go before you start to see a drop in customers.
If you want to increase your profits but you’re already making a good margin, it may be a good time to focus on scaling your business to increase your total revenue.
However, if your net profit is consistently falling below 10% and you’re struggling to make ends meet, you may want to consider focusing more heavily on improving your margins to set your business up for long-term success.
Revisit your business plan
Factors outside your control — like inflation and new competitors — can impact your profit margins. Perhaps you were the only shoe store in town but now a big-name store opened down the street, or consumers are opting to shop exclusively online. Or if your business relies on physical products, the rising costs of raw materials, labor and transportation may lead to a higher cost of goods sold (COGS).
If your profit margin isn’t where you want it to be as the market and economy changes, it’s time to update your business plan. Even if you’re experiencing the opposite — substantial growth, high customer retention — it’s still worth revising your business plan so you set higher goals.
If you need help getting started on your updated business plan, consider visiting a small business development center (SBDC) in your area or finding a SCORE mentor. There are also Women’s Business Centers and nonprofits like Accion Opportunity Fund that provide services for small business owners. Alternatively, you can hire a business consultant.
Evaluate the risks and rewards of taking on debt
If your company has healthy cash flow, plus savings set aside, small business financing can help take your company to the next level.
Scaling a business comes with many benefits, such as expanding your customer base, enhancing brand recognition and increasing sales. Depending on the size and industry of your company, you may even appeal to investors. If your services or products are in high demand, you can also consider opening a franchise. The sky’s the limit.
However, it’s important to consider the risks of taking on debt to scale your business. Scaling too quickly can lead to cash flow struggles, employee burnout or compromised quality. If you spread yourself too thin, you run the risk of not having the funds to repay the debt, which could negatively impact your business credit.
4 ways to track profit margin
Tracking your profit margin is important for understanding how your business changes over time and comparing your performance to other companies in your industry. Many tracking tools are available. Choose one that fits your needs and your budget.
- Basic pen and paper tracking works well enough for teaching a kid how to run a lemonade stand.
- Excel or Google Sheets offer small business templates that are adequate for tracking single-product businesses like a law firm, housekeeping service or food truck.
- Small business software like Quickbooks or Xero is needed when your business grows to include multiple product and/or service categories.
- Enterprise software from companies like Oracle and Workday is only needed — and affordable — when your business has scaled to complexity and profitability.
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