Profit margins are perhaps one of the simplest and most widely used financial ratios in corporate finance. A company’s profit is calculated at three levels on its income statement, starting with the most basic—gross profit—and building up to the most comprehensive: net profit. Between these two lies operating profit. All three have corresponding profit margins calculated by dividing the profit figure by revenue and multiplying by 100.
- Profit margin conveys the relative profitability of a firm or business activity by accounting for the costs involved in producing and selling goods.
- Margins can be computed from gross profit, operating profit, or net profit.
- The greater the profit margin, the better, but a high gross margin along with a small net margin may indicate something that needs further investigation.
- Profit margins vary by industry and should only be compared to those of similar companies.
- You can use computer software, such as Microsoft Excel, to quickly calculate profit margins.
How to Calculate Profit Margins
Types of Profit Margins
There are three different types of profit margins: gross profit margins, operating profit margins, and net profit margins. Each one provides you with a peek at how efficiently a company is operating.
Gross Profit Margin
Gross profit is the simplest profitability metric because it defines profit as all income that remains after accounting for the cost of goods sold (COGS). COGS includes only those expenses directly associated with the production or manufacture of items for sale, including raw materials and the wages for labor required to make or assemble goods.
Excluded from this figure are, among other things, any expenses for debt, taxes, operating, or overhead costs, and one-time expenditures such as equipment purchases. The gross profit margin compares gross profit to total revenue, reflecting the percentage of each revenue dollar that is retained as profit after paying for the cost of production.
The formula for gross profit margin is:
GPM=Net salesNet sales−COGS×100where:GPM=Gross profit margin
Operating Profit Margin
Operating profit is a slightly more complex metric, which also accounts for all overhead, operating, administrative, and sales expenses necessary to run the business on a day-to-day basis. While this figure still excludes debts, taxes, and other nonoperational expenses, it does include the amortization and depreciation of assets.
By dividing operating profit by revenue, this mid-level profitability margin reflects the percentage of each dollar that remains after payment for all expenses necessary to keep the business running.
The formula for operating profit margin is:
OPM=RevenueOperating Income×100where:OPM=Operating profit margin
Net Profit Margin
The net profit margin reflects a company’s overall ability to turn income into profit. The infamous bottom line, net income, reflects the total amount of revenue left over after all expenses and additional income streams are accounted for. This includes not only COGS and operational expenses as referenced above but also payments on debts, taxes, one-time expenses or payments, and any income from investments or secondary operations.
The formulas for net profit margin are either:
NPM=(RR−CGS−OPE−OTE−I−T)×100 orNPM=(RNet income)×100where:NPM=Net profit marginR=RevenueCGS=Cost of goods soldOPE=Operating expensesOTE=Other expensesI=InterestT=Taxes
What Is a Good Profit Margin?
That depends on the company and the industry. That's because profit margins vary from industry to industry, which means that companies in different sectors aren't necessarily comparable. So a retail company's profit margins shouldn't be compared to those of an oil and gas company.
Having said that, you can use a scale of how a business is doing based on its profit margin. A profit margin of 20% indicates a company is profitable while a margin of 10% is said to be average. It may indicate a problem if a company has a profit margin of 5% or under.
There are some studies that analyze profit margins by industry.New York University analyzed a variety of industries with net profit margins ranging anywhere from about -29% to as high as 33%. For instance, the study showed that the hotel/gaming sector had an average net profit margin of -28.56% while banks in the money center had an average net profit margin of 32.61%.
Regardless of where the company sits, it's important for business owners to review their competition as well as their own annual profit margins to ensure they're on solid ground
How to Calculate Profit Margin in Excel
You may find it easier to calculate your gross profit margin using computer software. One of the most common ones on the market is Microsoft Excel. Using spreadsheets can make things a little easier. Before you sit down at the computer to calculate your profit, you'll need some basic information, including revenue and the cost of goods sold.
In the first column (let's say this is Column A), input your revenue figures. In the next one (Column B), note the COGS. In Column C, you'll want to input the formula for your overall profit. So if you have figures in cells A2 and B2, the value for C2 is the difference between A2 and B2. Your profit margin will be found in Column D. You'll have to input the formula, though, (C2/A2) x 100.
The table below is fairly simple but gives you an idea of how it works:
Example of Profit Margin
For the fiscal year ended Oct. 3, 2021, Starbucks (SBUX) recorded revenue of $29.06 billion. Gross profit and operating profit clock in at $20.32 billion and $4.87 billion, respectively. The net profit for the year is $4.2 billion. The profit margins for Starbucks would therefore be calculated as:
- Gross profit margin = ($20.32 billion ÷ $29.06 billion) × 100 = 69.92%
- Operating profit margin = ($4.87 billion ÷ $29.06 billion) × 100 = 16.76%
- Net profit margin = ($4.2 billion ÷ $29.06 billion) × 100 = 14.45%
This example illustrates the importance of having strong gross and operating profit margins. Weakness at these levels indicates that money is being lost on basic operations, leaving little revenue for debt repayments and taxes. The healthy gross and operating profit margins in the above example enabled Starbucks to maintain decent profits while still meeting all of its other financial obligations.
What Is a Good Net Profit Margin?
A good net profit margin varies widely among industries. According to a New York University analysis of industries in January 2022, the averages range from nearly 29% for railroad transportation to almost -20% for renewable and green energy. The average net profit margin for general retail sits at 2.65% while the average margin for restaurants is 12.63%.
So a good net profit margin to aim for as a business owner or manager is highly dependent on your specific industry. It’s important to keep an eye on your competitors and compare your net profit margins accordingly. Additionally, it’s important to review your own business’s year-to-year profit margins to ensure that you are on solid financial footing.
Which Profit Margin Formula Is the Most Useful?
The most significant profit margin is likely the net profit margin, simply because it uses net income. The company’s bottom line is important for investors, creditors, and business decision-makers alike. This is the figure that is most likely to be reported in a company’s financial statements.
However, each formula has its own value for internal analysis. The gross profit margin can be used by management on a per-unit or per-product basis to identify successful vs. unsuccessful product lines. The operating profit margin is useful to identify the percentage of funds left over to pay the Internal Revenue Service and the company’s debt and equity holders.
Are There Other Profit Margin Formulas?
Yes. An adjusted gross margin is also useful for internal analysis. It is similar to gross profit margin, but it includes the carrying cost of inventory. Two companies with similar gross profit margins could have drastically different adjusted gross margins depending on the expenses that they incur to transport, insure, and store inventory.
Profit margin can also be calculated on an after-tax basis, but before any debt payments are made. This is referred to as an after-tax unadjusted margin. It more directly identifies the funds left over to pay lenders.
The Bottom Line
Profitability metrics are important for business owners because they highlight points of weakness in the operational model and enable year-to-year performance comparison. For investors, a company’s profitability has important implications for its future growth and investment potential. In addition, this type of financial analysis allows both management and investors to see how the company stacks up against the competition.
Profit margins are used to determine how well a company’s management is generating profits. It’s helpful to compare the profit margins over multiple periods and with companies within the same industry.
New York University. “Margins by Sector (US).”
U.S. Securities and Exchange Commission. “Starbucks Corporation Form 10-K, for the Fiscal Year Ended October 3, 2021,” Page 41.