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How to Work Out Profit Margins

How to Work Out Profit Margins

One of the most important aspects about running a business is understanding your margins. The two types of profit margins to understand are gross profit and Net profit and different calculations are needed for each one. For Gross profit, you need to subtract the cost of goods from your total revenue and for Net profit, you need to subtract all business expenses from your total revenue.

Net profit calculations are likely to result in a lower value than gross profit calculations, however, net profit is a more accurate reflection of the health and profitability of your business. This is why net profit is seen as a more reliable key performance indicator than gross profit.

Learn More About These Key Business Metrics

If you’re a business owner or a keen entrepreneur, you may have heard the term ‘profit margin’ before but do you know what it means? In this article, we will provide all the information you need to understand and calculate your profit margin and some ways these insights could be used to increase the profitability of your business.

How Do You Calculate Profit Margin UK?

The two main types of profit margins discussed in business are gross profit and net profit.

Gross profit is the difference between COGS and the total revenue of the company. COGS includes all costs associated with selling a product such as labour, materials, manufacturing and delivery.

Net profit on the other hand, means taking your COGS and all other business expenses (Including taxes and interest) and subtracting this from your total revenue.

Working Out Gross Profit Margins

The easiest way to work out your Gross profit margin is to subtract your total cost of goods (COGS) from the total revenue generated by your business. This calculation gives you your Gross profit margin. To calculate the profit margin as a percentage, take your gross profit and divide it by your total revenue.

As an example, if your COGS are £90,000 and your total revenue generated is £100,000, this would leave a Gross profit of £10,000 and a profit margin of 10%. The formula below can be used for calculating these totals:

  • £100,000 – £90,000 = £10,000 gross profit
  • £10,000 / £100,000 = 0.1 profit margin
  • 0.1 x 100 = 10% profit margin

Working Out Net Profit Margins

An alternative way to find your profit margin involves using your net income for the calculation. Net income is the sum of your total revenue minus all business expenses. Business expenses include things like tax, operating costs and interest payments. Like the gross profit margin calculation, to find your net profit margin, divide your net income by your total revenue.

If the total revenue of your business is £100,000 and your business expenses of £90,000 then your net income would be £10,000. Below is the formula needed to calculate these totals:

  • £100,000 – £90,000 = £10,000 net income
  • £10,000 / £100,000 = 0.1 profit margin
  • 0.1 x 100 = 10% profit margin percentage

These are the two most common formulas for calculating profit margin. Once you know your margins, lowering your COGS, raising product price or doing both can lead to increased turnover which in turn will increase business profitability.

Why Should You Calculate Profit?

So, why do businesses need to understand their profit margins? Well, the term itself relates to proceeds the business keeps as profit and is a key metric in understanding the performance of the business. This will help businesses understand how much profit they are making, and in turn, how well they are performing.

If the business has a high profit margin, it suggests they are operating effectively and generating a good profit margin per sale. If this margin is low, the business is likely to see low profitability.

Is Gross Or Net Profit A Better Metric?

Businesses have several different important metrics they can use to track overall performance but in terms of profit, what metric would give a more accurate representation of their financial position? Gross profit or net profit?

Gross profit is calculated by subtracting your cost of goods from your overall turnover. This value gives an idea of how much profit is being made on each sale, however, it only tells half the story. Gross profit does not include any other operating expenses such as taxation and advertising for example, although it can give you an idea of revenue, useful if one of your business goals is to increase turnover. However, it can also give the impression the business is in a healthier financial position than what it is.

Net profit on the other hand, gives a more accurate representation of your businesses profitability which is why it’s considered the more important business metric. To get this figure, we subtract all operating expenses from your total revenue which will give you your net profit and a clearer picture of whether you’re making money or not.

Don’t Forget Your Operating Profit Margin

As well as the gross or net profit margin which we have discussed, there is a third which is arguably just as important, and it’s called operating profit margin.

This is a key business metric used by investors to get an idea of how efficient the business is and how healthy their financial state is. It measures the amount of profit generated by the core business activities before any tax or interest liabilities are met. To calculate operating profit margin, you need to divide operating profit by total revenue.

For example, if the total revenue of your business is £100,000, your COGS is £70,000 and you have business expenses (excluding taxes and interest) of £10,000 then your operating profit would be £20,000. Below is the formula needed to calculate these totals:

  • £100,000 – £70,000 (COGS) – £10,000 (expenses) = £20,000 operating profit
  • £20,000 / £100,000 = 0.2 profit margin
  • 0.2 x 100 = 20% profit margin percentage

As with gross profit and net profit margins, a higher operating profit margin shows the business is efficient with good profitability whereas a lower margin indicates low profitability.

How Does It Relate To Gross & Net Profits?

The main difference in net profit margin and operating profit margin is taxes!

When we calculate the net profit margin, taxes and any interest payments are included within the business expenses that are subtracted from the total revenue. However, when calculating operating profit margin, any tax or interest liabilities are excluded.

It’s important for businesses to distinguish between these different metrics as they can provide valuable insights into different aspects of the business and its financial stability. Understanding the difference between gross profit, net profit and operating profit margins can provide businesses with valuable information that they can then use to maintain or increase turnover and profitability.

Can You Use Accounting Software For Profits?

There are a few different accounting software available which businesses can use to track their finances and get valuable information on their financial position. Most accounting software available will automatically calculate metrics like operating profit based on the information provided which saves having to manually derive these figures reducing the risk of an incorrect calculation potentially causing an issue.

The information provided by your accountancy software can also prove to be a useful resource in maximising profit, if used properly. For example, it can help you to track inventory levels, manage customer data and allocate resources to help the business run more efficiently.

Some older accountancy software systems may not automatically provide information on these margins but using the formulas provided above will allow you to calculate your margins. Just be careful to input the correct figures and be consistent with the method you use to avoid discrepancies.

What Is A Good Net Profit Margin?

Well, ultimately that may depend on the industry that the business trades in. Profit margins between sectors are rarely comparable and this is an important consideration when comparing your margins against other companies. For a more accurate comparison, it’s sensible to reference like-minded companies in the same industry. This may give a better indication of whether the target you set for your business’s profitability is realistic.

Even though each industry is likely to be different, from a general perspective, anything between 5% – 10% or higher is considered to be good. The result being the company making £10 profit for every £100 generated in sales. Obviously, the higher the profit margins, the healthier the company’s balance sheet which can remove any potential restrictions on funding for such things like advertising and expansion.

Across all industries, the main goal of any business is to make a profit. By having a high profit margin, it will generate enough profit to cover COGS, all expenses and still leave a surplus to cover other things like any potential investor returns.

How To Increase Profits?

All businesses’ main goal is to make a profit. It’s tricky to know where to start, but there are lots of ways to do this. Below, we will look at a couple of examples:

  • Reduce costs by increasing process automation leading to less wasted time and process inefficiencies
  • Negotiating with suppliers for discounted rates
  • Adding new marketing channels to increase revenue and sell on different platforms
  • Launching new or improved products or services

Most businesses will need a mix of both cost reduction and turnover-enhancing ideas to increase revenue but as each business and industry differ, it’s important you consider the different business metrics and implement any actions you think have the best chance of increasing profitability for your business.

Margin vs Markup

There are a variety of different buzzwords and abbreviations in business which can be confused, and two of the most common are margin and mark-up.

Let’s try and clarify what both terms mean.

The two main strategies that businesses use when trying to determine pricing is margin and mark-up. Margin is the difference between what you pay for a product and what you then sell it to the consumer for. In contrast, mark-up is the amount added to a product to increase profitability. Both are effective pricing strategies but which one to use will depend on several different factors.

There are advantages and disadvantages to both strategies when determining pricing. With margin, the business will know exactly what profit they are making on each product which can be useful for future financial projections.

Profit on each product will be known which can help with business planning. By comparison, businesses with many products might use mark-up as it’s less complex and quicker to calculate by simply adding a fixed percentage to the cost of the product.

Which Pricing Strategy Should You Use?

The nature of your business will determine which strategy to use. For example, if you sell a large variety of products, it will be more efficient to calculate a fixed percentage mark-up on each product rather than having to calculate profit margin on each product.

An example of this would be if you have a wide range of products that will vary on price. If one product costs £300 and another product costs £30, it would be hard to maintain a consistent margin across all products. This is where the flexibility of the mark-up strategy would be advantageous as it would be consistent across all products.

On the other hand, if you wish to have a tight control on costs, then understanding your profit margin on each product would be useful. As an example, if you sell the product for £120 and your COGS is £100, then your profit margin is 20%. However, what if the COGS was to rise to £110? This would negatively impact your profit margin – which drops to 18.2% – and although a small change, directly impacts on profitability if the price of the product was to remain the same.

Working out what works best for your business may mean having to adopt both strategies and then track which is more effective.

Summary

Hopefully, you now have a clear understanding between the different business terms gross profit margin, net profit margin and operating profit margin. By using the formulas provided above, it will allow you to calculate them and then use them to increase profitability within your business.

Each of the different metrics provide different insights that your business can use to monitor performance, financially and operationally. This means it is imperative that the different terms are understood as these metrics can provide some valuable information which you can then use to improve efficiency and profitability.

Typically, a net profit margin of between 5% – 10% is seen as a good return as it should provide enough to cover all expenses and provide a return for investors.

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