Making Sense of Margins: Calculating Gross & Net Profit Margins

If you own a business, you understand better than anyone the importance of profit. You probably even prioritize profitability as a key metric with regular monitoring and are invested in maximizing revenue streams and cost efficiency. This blog post will help you make sense of these crucial calculations, delve into key concepts, and take your profitability to the next level.

What Is Profit Margin?

Profit Margin Types Explained

Crunching the Numbers: How to Calculate Your Profit Margin

5 Proven Ways to Improve Profit Margins

What Is Profit Margin?

Profit margin is the percentage of money a company makes for every $1 of revenue. In simpler terms, it’s the amount left after all costs are deducted. You can calculate profit margin by dividing the net profit — the total revenue minus total expenses or costs — by the total revenue. Then, multiply that number by 100 to get a percentage. The higher the percentage, the more profitable your business is. Is your profit margin above 10%? Congrats! This is considered a good margin for most businesses.

(Total Revenue – Total Expenses) / (Total Revenue) × 100 = Profit Margin

Profit margin is a figure that businesses (as well as lenders and investors) use to determine whether a company is financially sound. If a company is publicly traded, there are strict reporting requirements surrounding profits and losses according to a set schedule, usually quarterly or annually.

Profit Margin Types Explained

There are several types of profit margins that focus on varying aspects of a business’ finances. Here are some of the most common and important to consider as you assess overall financial performance.

• Net Profit Margin is the profit percentage that companies produce from total revenue. This figure provides insight into how successfully a business is managing expenses relative to revenue. The higher the net profit, the more profitable your business. You can use insights from your net profit margin calculations to make financial decisions, such as evaluating your pricing strategy and assessing how efficiently your business is running.
• Gross Profit Margin is the percentage of profit left over after the cost of revenue or cost of goods sold (COGS) is subtracted from the total revenue. Companies with a higher gross profit margin are doing well at managing costs. By tracking this information over time, stakeholders can see just how effective cost control measures are.
• Operating Profit Margin, also referred to as “earnings before interest and taxes” or EBIT, is the percentage companies calculate to demonstrate profitability in comparison to core operating costs. This metric indicates just how financially sound a company is.

Crunching the Numbers: How to Calculate Your Profit Margin

To determine the profit margins we just mentioned, you’ll need to understand some of the key variables that go into each calculation.

• Cost is the estimated price of something; an amount that needs to be spent to obtain something else. For a services business, your billable resources would be an example.
• Revenue is the total amount of money brought in from the sale of goods or services. This is also known as gross profit.
• Net sales is the total amount of money generated by a company without taking into account any sales returns, goodwill, allowances, or discounts.
• Net profit is what’s left over when all expenses have been subtracted.
• Cost of goods sold (COGS) is the direct cost a company incurs when goods are produced and sold.
• Operating profit is any profit gained before interest and taxes are deducted.

Bookmark this page and return to these formulas when it’s time to take a closer look at your business’ financials.

• Net profit margin = (Net Profit / Revenue) x 100
• Gross profit margin = ( (Net Sales – COGS) / Revenue ) x 100
• Operating profit margin = (Operating Profit / Revenue) x 100

5 Proven Ways to Improve Profit Margins

Now that you’re familiar with common profitability terms and know how to calculate net profit margin, gross profit margin, and operating profit margin, you’re ready to plug in your own values and assess your business’ financial health.

Are your margins not quite where you want them to be? Consider these techniques to help make improvements and avoid any pesky, unforeseen circumstances.

• Reduce operating expenses to offer your customers more competitive pricing, thereby increasing sales and market share.
• Streamline processes to create efficiencies and reduce production or delivery time. However you choose to look at it, creating efficiencies is vital for your business to save money and boost profitability.
• Focus on customer loyalty by clearly conveying the difference between your product or service and your competitors’, as well as how and why the customer needs it. Here’s another important formula: Brand loyalty = consistent business. Not only do loyal customers tend to buy more, but word of mouth is responsible for bringing in new customers. Rinse and repeat!

• Adjust prices to ensure a consistent profit across varying price points. This is where market research becomes useful to gauge competitors’ price points.
• Make high-margin products/services the priority to understand your costs and develop a pricing strategy. Ensure that the pricing reflects the value proposition and competitive landscape, optimizing your revenue streams effectively.

Wondering how to automate these valuable reporting insights and analytics? Get in touch to discuss how Solvit can help.