Profit Margin Formula

What is the Profit Margin Formula?

Profit margin formula shows a percentage of revenue earned after all the business costs, business taxes, depreciation, interests and other expenses have been deducted. It is the most significant margin used by the business owners to know the total profit percentage earned by a business over a period of time. It is also known as net margin, net profit margin or net profit ratios in business terms.


We get a profit margin by dividing net income by sales.

When net profit is divided by net sales, the product we get is  a net profit margin. Profit margin and gross profit margin formulas are generally used by small companies for comparing similar industries. Profit margin is always represented in percentage. The higher the profit margin, the more profitable the business will be. Through this article, we will study profit margin formula, gross profit margin formula, net profit margin formula, formula of gross margin, what is the profit margin formula, why profit margin is important, what is a good profit margin, etc.


Profit Margin Formula  = Firm's Net Income / Firm's Net sales * 100


Types of Profit Margin

There are two different types of profit margin namely:

  1. Gross Profit Margin

  2. Net profit Margin

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Let us discuss both gross profit margin and net profit margin in detail.

Gross Profit Margin - Gross profit margin is a measure of the company profitability, formulated as the gross profit as a percentage of revenue. Gross profit is the amount that is left after subtracting the cost of goods sold or direct cost from the revenue.


Generally, the cost of goods sold is the measure of the direct cost required to produce goods or services such as materials and labor. It does not include indirect expenses such as distribution costs, marketing and accounting. It makes the gross profit margin useful for tracking the direct cost of operations such as the percentage of sales. Other profit margin ratios such as net profit margin reflect distinct measures of profit.


The gross profit is calculated by subtracting the cost of the goods sold from the revenue of the business.


The formula of gross profit margin is expressed as:


Gross Profit Margin Formula - Firm's Gross profit ÷ Firm's Net sales


In the gross profit margin formula given above, gross profit is calculated as net sales or  total revenue of a company - cost of goods sold.


Net Profit Margin - Net profit margin is the percentage of revenue that is left after all the expenses have been deducted from the sales of a company. This measurement discloses the amount of profit that a business can get from its total sales. The net profit margin is generally made for a standard reporting period such as month, quarter, or years and is included in the income statement of the business. The net profit margin generally measures the overall success of a business. A higher net profit margin shows that a business is pricing its products accurately and is exercising optimal cost control.


The results of the net profit margin can be compared within the same industry as they all are subject to the same business environment and customer base and have approximately the same cost structures.


Generally, a net profit margin in excess of 10% is considered optimum though it relies on the industry and structure of the business.


Net Profit Margin Formula = Firm's Net Profit ÷ Firm's Total revenue * 100


In the above net profit margin formula, net profit is calculated by subtracting all the expenses form the total revenue of the company.


Why is Profit Margin Important?

Profit margins are required to be calculated for financial statements that are necessary for investors or banks who are considering offering loans to the business. The profit margin tells business owners whether the company is performing well or not or the company needs to change its approach.


For example,  let's consider a small business owner who runs the business and sees that his operating profit margin is too low when compared to his industry. He then analyses the company’s manufacturing process and realizes the efficiencies he can take advantage of. These efficiencies when realized by the business owners will save both time and money. A year later, when the business owner sees his profit figures again, he could see that his operating profit margin is on par with his industry.


What is a Good Profit Margin?

A good profit margin generally varies by industry, but approximately a 1.% of the net profit margin is determined as average, a 20% profit margin is considered high or good and a 5% profit margin is considered very low. Again, these percentages of profit margin vary broadly by industry and company size and can be impacted by various internal and external factors.


Solved Examples

1. Calculate a profit margin when you purchase a water bottle for Rs.500 and sell it for rs. 550.


Solution: 

Net sales  = Rs. 500

Net Profit = RS. 550 - RS. 500

Net profit = Rs. 50

We can get a profit margin by using below profit margin formula:

Profit Margin = Net profit/Net Sales * 100

Profit margin - 50/150 * 100

Profit margin  - 0.33 * 100

Hence, Profit Margin = 33.33%


2. Find the gross profit margin of a company is the gross profit of a company is Rs. 600,000 on a net sales of Rs. 500,000.


Solution:

Gross Profit = RS. 600000

Net Sales = Rs. 800000

We can get a gross profit margin by using below gross profit margin formula:

Gross Profit Margin = Gross profit/Net Sales * 100

Gross Profit margin =  6,00,000/8,00,000 * 100

Gross Profit margin = 0.75 * 100

Profit Margin = 75%

Hence, the gross profit margin of a company is 75%.


Quiz Time

1. Choose the appropriate formula for gross profit margin.

  1. Revenue/cost of good sold

  2. (Revenue - cost of good sold) /Cost of good sold

  3. Cost of good sold/ Revenue

  4. (Total Revenue - Cost of good sold)/ total revenue.

2. A business has following balance:

Turnover = 12000

Cost of sales = 9654

Total expenses = 2000

Find the net profit margin of the business.

  1. 3%

  2. 2%

  3. 4%

  4. 1%

  5. 0.5%

3.  A business shas following balance:

Turnover = 12000

Cost of sales = 9654

Total expenses = 2000

Find the gross profit margin of the business.

  1. 19.5%

  2. 20.5 %

  3. 21.5 %

  4. 18.5 %

  5. 22.5%

FAQ (Frequently Asked Questions)

1. Why is it Important to Calculate the Gross Profit Margin?

Ans: Gross profit is a measure of the profit earned on sales. It is one of the items that appear on the income statement of a business. It represents the profit portion of the total revenue earned by the company after subtracting the cost of the goods sold. It is important to calculate gross profit margin using the formula of gross margin as it determines the profitability and financial position of a business. The higher the profit margin the more the company is profitable and the company stands in a good position to invest in. It is basically used to evaluate the efficiency of the business in terms of the company making use of its labor, raw materials, and other supplies. Hence, the gross profit margin decreases and increases over a period of time and helps in determining the reason behind the fluctuations. It enables the business to take an effective decision if any negative changes are found in the gross profit.

2. Why is it Important to Calculate the Net Profit Margin?

Ans: Net profit margin is the money that is left over after subtracting the total business expense form the total revenue of the company. In other words, the net profit margin calculates almost all the financial transactions of a business. It is important to calculate net profit margin as it gives an estimation of the money available to pay to the owners or invest back into the business. The other reasons why it is important to calculate net profit margin are:

  1. It shows the amount of tax that has to be paid by the business owner.

  2. Banks and other creditors that provide loans to the business use the net profit figures to get a better understanding of the business and to evaluate the suitability of loans as it gives the banks and creditors an indication about the company’s ability to pay back the loans.

  3. It gives proper understanding to the shareholders if they are seeking to invest in the business. A healthy and consistent net profit calculation will give investors confidence that they will get high returns.