Calculating your profit margin is crucial for understanding the health of your business and is a key indication of strong, overall business performance.
Improving your profit margin means there’s more money in the business to fuel growth. Knowing your margins helps you to set prices, but also gives you room to move when competing on price in the event of a slow period.Conversely, tighter margins may indicate the need to make critical improvements in the business. In a worst case scenario, cuts may be necessary.
Gross Profit Margin vs. Net Profit Margin
There are two types of profit margin that are commonly referred to in business. Gross profit margin and net profit margin. When you're seeking to understand how to calculate profit margin, first you'll need to distinguish between the two calculations.
Gross Profit
Gross profit calculates the total revenue from your goods or services minus the cost of those goods or services (sometimes referred to as COGS). So, the only expenses included are those directly related to the creation of those specific goods and services. Other expenses, such as your payroll, rent, utilities and other business expenses are not included in this calculation.
The figures used to calculate your gross profit can be found on your Profit & Loss Statement (P&L). The top line of the P&L is your revenue and the cost of goods sold (COGS) reflects the direct expenses for those goods or services. Your gross profit is calculated by subtracting the cost of goods and services from your revenue.
Net Profit
Net profit differs in that it includes all business expenses, not just the direct cost of goods or services. These expenses include regular operational costs, such as utilities, payroll and other typical recurring expenses but also includes one-payments, such as taxes and contractor invoices. Any additional income not related to the selling of goods or services, such as investment income, must be accounted for as well.
By including all businesses expenses in a net profit calculation a more detailed picture emerges of the business health. In fact, the net profit is often referred to as the 'bottom line' on a profit and loss statement. (P&L)
How to Calculate Profit Margins
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Gross Profit Margin
Gross Profit / Total Revenue x 100 = a percentage of income retained as profit after accounting for the cost of the goods or services
Example:
Revenue from the top line of your P&L is $10,000
Cost of goods or services from your P&L is $8,000
Your gross profit is $10,000 -$8,000 = $2,000
Gross profit margin is $2,000 / $10,000 x 100 = 20%
Net Profit Margin
Revenue from the top line of your P&L is $10,000
Cost of goods or services from your P&L is $8,000
All other expenses are an additional $1,000
Your net profit is $10,000 - $8,000 - $1,000 = $1,000 (this figure can be found on the bottomline of your P&L)
Net profit margin is $1,000 / $10,000 x 100 = 10%
It's important to understand how to calculate profit margin to have a thorough understanding of the health of your business. In fact, both gross profit margin and net profit margin are two common key performance indicators (KPIs) that businesses closely monitor.
Tracking and understanding your profit margin is critical to fuel business growth. It helps to set prices and can give you a buffer when times are tight. Profit margins also help you identify and react to issues, helping you to uncover problems in your business and take action before it’s too late.
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