What is a Profit Margin?
Profit margin indicates the profitability of a product, service, or business. It’s expressed as a percentage; the higher the number, the more profitable the business.
Types of Profit Margins
Small businesses, including retailers, often look at two types of profit margin:
- Gross profit margin
- Net profit margin
Gross Profit Margin
Gross profit margin usually applies to a specific product or line rather than an entire business. Calculating the gross profit margin helps a company determine pricing decisions because a low gross profit could mean that the company needs to charge more to make selling a specific product worthwhile.
Calculate gross profit margin by subtracting the cost of goods sold from net sales. Divide the resulting number into the net sales to get the ratio, which represents the percentage. For example, if sales are $8,000 and costs total $6,000, the difference between the two is $2,000. Divide that difference by sales – $8,000 – and multiply by 100 to get 25 percent. That is the gross profit margin.
Note that cost of goods sold includes direct product costs but doesn’t include indirect costs, such as rent, office supplies, and so on.
Net Profit Margin
Unlike gross profit margin, net profit margin is a calculation that expresses the profitability of an entire company, not just a single product or service. It is also expressed in a percentage; the higher the number, the more profitable the company. A low profit margin might indicate a problem that is interfering with profitability potential, including unnecessarily high expenses, productivity issues, or management problems.
Calculating the net profit margin is very similar to the steps for gross profit margin, but this process requires the entire company’s revenue and costs, not just those of one product. Divide the company’s net income (the profit after expenses are deducted from gross income) into total sales, then multiply the result by 100 to get the answer expressed as a percentage. Let’s say gross sales are $150,000 and expenses are $75,000. That means net income is $75,000. Divide that number into gross sales, $75,000 divided by $150,000, to get .50. Multiplying .50 by 100 equals 50 percent, the net profit margin.
People using net profit margins to determine a company’s profitability are cautioned not to compare a business in one industry to a business in another. Industry characteristics vary so much that it’s unrealistic to expect a restaurant, for example, to be comparable to an auto parts retailer.