How To Calculate Profit Margin (With Formula & Tips)

Profit margins are one of the most widely used financial ratios in the corporate finance industry. A business calculates its profit at three levels on its income statements. This starts with the most basic profit, gross profit.

Next is operating profit, and last, and most comprehensive, is net profit. All three of these profits have profit margins. Providing the profit margin will convey the relative profitability of company activity. It accounts for all costs involved in the production and sales of a product.

What is Gross Profit Margin?

Gross profit margin is a metric used by financial analysts to help assess a company’s financial health. This metric calculates the amount of money left over from sales after subtracting the cost of goods sold. This metric can also be referred to as the gross margin ratio too.

The profit margin helps an organization express how much of every sales dollar a company keeps in its earnings. It takes into account the costs of service to find the closest number to actual profit.

The Formula for Gross Profit Margin

To calculate any profit, including gross, operating, and net, you can calculate the profit margin by dividing the profit (revenue minus costs) by the revenue. If you multiply this by 100, you can get the percentage of your profit margin.

The gross profit margin is an indicator of profits in relation to production costs. To calculate your profit margin, you’ll want to calculate it as gross profit. The gross profit represents your entire revenue minus the cost of goods sold, meaning this figure covers the costs of producing your product, including labor, materials, and other associated costs.

The formula for Gross Profit Margin is as follows:

Gross Profit Margin = Net Sales – Cost of Goods Sold / Net Sales

So, if you paid $10,000 for goods and sold them for $12,000, your gross profit would come to $2,000. If we divide the figures by total revenue, the gross profit margin is 0.2. Multiply this number by 100, and you get your percentage of profit margin, which comes to 20 percent.

Profit vs. Revenue

In finance, accounting, economics, and law, profit and revenue can be defined as very different things. But when we’re thinking about the basics, profit is referencing the amount of money remaining after all expenses and overhead are taken out in a specific period. Revenue refers to the total amount earned by a company without subtracting the cost of goods sold or the expense of services within that same period.

When we dive deeper into revenue, we can understand that a company’s income is obtained based on its business. It refers to any income earned from business operations. Revenue is also considered an increase in assets or a decrease in certain liabilities caused by the service provided to clients.

What Does ‘Gross Profit Percentage’ Mean?

After you’ve completed finding the gross profit percentage, you’ll want to understand what it is and what you can understand from it.

For those who don’t work with or for your company, the gross profit percentage represents how efficient your business is as it produces its goods and services. This is a common request for many companies. Most people calculate gross profit in both dollars and percentages for their annual financials.

Most importantly, your annual gross profit percentage tells you what portion of your earnings are available to cover company overhead, company taxes on profits, and net profit.

Of course, determining financials isn’t always black and white. There may be questions to ask yourself each month when calculating gross profit percentage. You might ask yourself or your team if it was a typical month for your company? Were there any roadblocks or challenges that might have altered your financials for that month?

What are the projected revenues for the entire year? Are you still on track to meet your goals, or do alterations need to be made? Will the projected income, combined with gross profit percentages, be enough to meet the business overhead and tax costs while maintaining a profit?

What Will Your Gross Profit Margin Tell You?

The gross profit margin you calculate can tell you several things about a business. If an organization’s gross profit margin is inconsistent and constantly fluctuates, this may be a sign of poor management practices or an inferior product in the market. However, as mentioned previously, it’s important to look at the full picture.

For example, a business may justify fluctuations in cases where they may have made significant changes to their business model or operations. There would be no reason to be concerned in a case like this since the volatility is temporary.

In different instances, the gross profit margin may give insight into a company’s supply chain functions. For example, if an organization chooses to automate functions within their supply chain, they may have a high investment, but the cost of goods would decrease over time. Due to automation, lower labor costs would offset the initial investment.

Additionally, you may see disparities due to product pricing adjustments. Depending on the company, pricing structures may vary. But if a company sells its products at a higher rate, it will have a higher gross profit margin with all other things equal.

However, this all needs to be balanced correctly. If the product is priced too high, the organization may have trouble selling it at all, which may impact market share.

Why Is Gross Profit Margin Important?

For business owners, profitability metrics are incredibly significant. These metrics can highlight weaknesses within the business’ operational model and tell a story with year-over-year metrics. This is incredibly significant for organizations that rely on investors, as they are number-driven individuals and will look deeply into profitability metrics.

These metrics have a lot of implications for future growth and investments. Additionally, using a gross profit margin will allow the management team and investors to see how competitive the company is in the market.

Ultimately, profit margins show how well a company’s management is generating profits. By comparing profit margins over various periods against others in the industry, the company can see where they need to improve and where they may be doing well.

For example, any money left over after covering the cost of goods is used to pay off other operating expenses. If it’s high, the company saves more on each dollar of sales to service its additional operating costs and business responsibilities.

On the other hand, if a company can’t earn an adequate gross profit percentage, it may be difficult to pay its operating expenses.

Author

Caitlin Mazur

Caitlin Mazur is a freelance writer at Zippia. Caitlin is passionate about helping Zippia’s readers land the jobs of their dreams by offering content that discusses job-seeking advice based on experience and extensive research. Caitlin holds a degree in English from Saint Joseph’s University in Philadelphia, PA.