How to calculate and improve your profit margin
What is a profit margin?
Profit margin is the percentage of revenue that remains after a company has paid operating costs and expenses. The higher the percentage, the greater the profit.
For example, suppose you generate $500,000 in revenue but have $450,000 in operating costs and expenses. You’ll have a lower profit margin than a business that makes $100,000 in revenue but only has to deduct $25,000.
You can find the figures you need to calculate your profit margins in your profit and loss statement.
Types of profit margins
Gross profit margin
Gross profit margin refers to the remaining revenue after deducting the cost of goods sold (COGS). COGS includes expenses directly related to producing and manufacturing your products, such as materials, storage and labour costs. The gross profit margin tells you how much you spend per product, which can be helpful when determining pricing.
Operating profit margin
The operating profit margin is the revenue left after removing COGS and all other operating costs. These expenses include costs associated with running your business, such as the administrative and marketing spend. Operating profit is a bridge between gross and net profit and an indicator of how you manage operating expenses.
Net profit margin
Net profit margin refers to the revenue remaining after deducting COGS, operating costs and any other expenses your business incurs. These costs include things like debt payments, one-time fees and taxes. Net profit margin is your “bottom line” and shows you how much actual profit you have.
Why do profit margins matter?
Your profit margins show precisely how your revenue impacts your bottom line. A clear picture of your income and expenses reveals the overall health of your business, which is crucial if you want to attract investors or take out a loan.
Additionally, knowing your profit margins can help you identify areas for cost reduction and efficiency improvements. For example, if your gross profit margin is high but your operating profit margin is below average, there may be opportunities to reduce operating costs.
Understanding your profit margins can also help you spot any pricing issues — for instance, if your gross profit margin is low, you might not be charging enough.
What is a good profit margin?
Generally, profit margins range from 5% (poor) to 20% (excellent), with 10% considered a “good” margin.
However, it’s important to note that profit margins differ widely between industries. For example, hospitality businesses typically have low margins due to high overhead costs and operating expenses. In contrast, companies with low overhead, such as consultancies, tend to have much higher profit margins.
Additionally, numbers vary depending on the profit margin type. Since gross profit margin doesn’t subtract all expenses, it'll naturally be higher than net profit margin. The most critical margins to focus on are your operating and net profit margins because they provide a more realistic view of your company’s financial health.
How to calculate profit margins (with examples)
Gross profit margin
You can calculate your gross profit margin by dividing your gross profit by revenue and multiplying it by 100:
Gross profit margin = gross profit / revenue x 100
For example, if a watch brand made $150,000 in revenue from selling watches but spent $100,000 making them, it'd have a gross profit margin of 33% ($50,000 / $150,000 x 100).
Operating profit margin
You can calculate your operating profit margin by dividing your operating profit by revenue and multiplying it by 100:
Operating profit margin = operating profit / revenue x 100
For example, if a fashion brand had revenue of $2 million, COGS of $600,000 and operating costs of $400,000, its operating profit margin would be 50% ($1 million / $2 million x 100).
Net profit margin
You can calculate your net profit margin by dividing your net profit by revenue and multiplying it by 100:
Net profit margin = net profit / revenue x 100
For example, if a perfume brand has a total revenue of $3.5 million and a net profit of $700,000 after COGS, operating costs and taxes, it'd have a net profit margin of 20% ($700,000 / $3.5 million x 100).
How to improve your small business profit margins
Track income and expenses
Knowing what’s coming in and out of your bank account is essential, particularly regarding your expenses. Some costs, like salaries, supplies and warehouse space, are necessary, but monitoring your accounts may reveal excess expenses you can remove.
Buy products in bulk
If you run a business that relies on buying materials or products, bulking in bulk can lower your supply costs. By saving funds, you can increase your operating and net profit margins.
Automate repetitive business activities
Focus on keeping existing customers
It’s more cost-effective to sell to existing customers than to attract new ones. By seeking out opportunities to cross-sell or up-sell to customers, you can improve your bottom line without the additional marketing expenses and activities.
Track your profit margins with MYOB
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