Profit Margin: What It Is and How to Calculate
Laura Roden’s career in financial services has covered the spectrum from investment management, brokerage, banking and corporate finance to teaching finance and entrepreneurship at the college and graduate school levels. She earned both her undergraduate and MBA degrees from Harvard University, and holds Series 7, 63 and 65 FINRA licenses. She has been a featured speaker on finance topics at the Milken Global Conference, the New York Society of Security Analysts, the Inc 500 conference and the Angel Capital Association as well as many other venues.
Profit margin is a measure of how many cents of profit are generated per dollar of sales. Always shown as a percentage, profit margin is used to track business performance trends over time and compare profitability between competitors.
Understanding how to calculate your profit margin — and how to improve it — can help you make more informed decisions to move your business forward.
What is profit margin?
Simply stated, the word “profit” means sales minus expenses; profits are expressed in dollars. The phrase “profit margin” means profits divided by sales; profit margin is expressed as a percentage. To calculate profit margin you’ll need to know these 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 and management salaries.
- 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.
Types of profit margin
As shown in the list above, three different types of profit 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.
Gross profit margin
This important metric tells you what percentage of your revenue is left after deducting the direct cost of making your product or service. If your gross profit is negative, it means you’re losing money on every sale and you must figure out a way to raise prices or cut costs before you go out of business.
To calculate: Gross profit / revenue = gross profit margin
Example: Gross profit of $25 revenue of $100 = gross profit margin of 0.25, or 25%
Operating profit margin
Operating margin tells you what percent of your revenue is left over after deducting all your direct and indirect costs. This number may occasionally be negative during a slow season, but you’ll need to increase sales soon to pay your bills.
To calculate: Operating profit / revenue = operating profit margin
Example: Operating profit of $10 / revenue of $100 = operating profit margin of 0.10, or 10%
Net profit margin
Sometimes called “net margin,” this metric tells you what percent of your revenue is left after you’ve paid everything including loan interest and income taxes. If it’s negative it means you’ll soon be in trouble with your lenders.
To calculate: Net profit / revenue = net profit margin
Example: Net profit of $5 / revenue of $100 = operating profit margin of 0.05, or 5%
Adjusted gross margin
Businesses that keep inventories on hand of materials or finished goods sometimes calculate an adjusted gross margin that estimates 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.
This is a complex analysis requiring many thoughtful assumptions that will be specific to your business. If your business carries a lot of inventory, consider hiring an accountant to help you calculate your adjusted gross margin.
To calculate: (Gross profit – all the direct and indirect costs of holding inventory) / revenue = adjusted gross margin
Example: (Gross profit of $25 – $5 in direct and indirect costs of holding inventory) / $100 revenue = adjusted gross margin of 0.20, or 20%
What’s a good profit margin?
While a higher profit margin is always nice, what’s considered a good profit margin is based on the type of business you’re in. For example, businesses offering everyday low prices will have lower net profit margins than businesses selling luxury goods at premium prices. In 2023, low-price retailer Walmart had a slim net profit margin of only 2.4%. In comparison, luxury retailer Ralph Lauren had a net profit margin of 8.1%, almost four times as high.
Businesses that simply buy a product from a manufacturer and resell it to the public are known for having low gross profit margins, while businesses that create and sell their own products can have very high ones. For example, the supermarket chain Publix had a 26% gross profit margin in 2023, while Pepsico, which makes many products that Publix sells, had a 54% gross profit margin.
To learn what a typical profit margin is for your business, you can either do an internet search for gross or net margin by industry, or you can look up the financial statements of public companies in your sector and calculate their profit margins yourself.
Profit margin vs. markup
Profit margin is often confused with “markup.” Both calculations are used for analyzing how the price of a product compares to its cost of goods. However, they’re calculated in different ways — profit margin compares profit to revenues, while markup compares profit to COGS. Here’s an example:
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:
$75 gross profit / $25 COGS = 3.00, or 300% “markup”
How to increase profit margin
The larger your profit, the larger your profit margin ratio. Since profit equals revenue minus expenses, the two plans of attack are (a) increasing revenues and (b) reducing expenses. Here are some specific approaches to consider:
- Raising prices will increase revenue as long as you don’t make prices higher than the market will bear.
- Reaching more customers through advertising or expanded hours of operation will increase revenue — but watch out for offsetting expenses.
- 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.
4 ways to track profit margin
Tracking your profit margins is important for understanding how your business is changing over time and evaluating how you’re doing compared 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.