Even though organisations possess unique missions and visions, the primary defining end goal of any business is to make a profit. Without one, a company cannot sustain itself, and will be forced to close; it is for this reason that every business owner should know how to calculate profit margin accurately.
First, though, it's necessary to understand what the term means, and why it is so important.
Profit margin is one of the commonly used profitability ratios to gauge the degree to which a company or a business activity makes money. It represents what percentage of sales has turned into profits.
In simple terms, it is an indication of how many cents of profit you have created for each dollar of sale. For example, if you sell a product for $10, and your production costs are $7, then your profit margin would be $3 – or 30%. The higher the percentage of your profit margin, the more profitable the business is, and the more income the business owner will receive.
How to Calculate Profit Margin
Take the following fictional business example, where the company in question sells three products and provides two supporting services.
Starting Business
We want to calculate the profit margin for the period between June 2019 and October 2019, so we only want the figures for this period.
Next, we want to calculate the revenue for this period. This is done by combining the total monies received each month for the products and services offered, and then adding those sub-totals together to get a grand total.
Then, we need to deduct the expenses, which are listed in the second table as expenditure. Again, we want to add the monthly sub-totals together to arrive at a grand total.
We then subtract the expenditure total from the revenue total, which in this example gives us a net profit of $21,149.
Finally, we divide this net profit by the total revenue ($84,957), leaving us with a profit margin of 0.25 – or 25%.
If you're still unsure, here is a more comprehensive breakdown of how profit margin works:
1. Know the Difference Between Your Profits
Before you can begin, you should first be able to understand the difference between gross profit, gross profit margin and net profit.
Gross profit is the revenue earned from the selling of your goods and services, minus the costs of making the goods you have sold. However, the gross profit margin is your gross profit divided by your revenue. It is designed to identify how much income is left over after paying for the cost of goods sold. Meanwhile, net profit – also referred to in accounting terms as a company’s bottom line – is the company's actual profit after all business expenditures. It is calculated by deducting administrative and other relevant expenses from your gross profit.
Your company's bottom line is its most important metric, and clarifies if your business plan is working or if you are operating at a loss.
2. Define the Calculation Period
You also need to define the period for which this margin will be measured. The period you select – which could be a particular month (or months) of the year, a yearly quarter, or a specific year (or years) – ultimately depends on why you are calculating your profit margin. If you want to convince someone that your business is healthy for the purpose of attracting investment, then it will be necessary to display your profit margin over an extended period. If you just want to calculate your profit margin for your own benefit – either to identify trends or to get an understanding of your company's financial health – then perhaps calculating across a shorter period would be more suitable.
3. Calculate Your Revenue
Once you know the period that you want to calculate for, the next step is to work out your total revenue during this period. Your revenue is all the money that you make through the sales of your goods or services.
4. Deduct Expenses
Now that you know the exact revenue that you made during the period you are interested in, you are ready to find out what your net income was. Of course, in the majority of cases, you have to spend money to make money, so revenue alone is not a reliable indicator of your company's performance.
This means that you have to calculate all of your production expenses, including any material, labour and transport costs incurred over the same period, and subtract them from your revenue. This will then give you your net profit.
Note that if your expenditure is larger than your revenue, then your pricing structure is all wrong. You should have a desired profit margin factored into your business strategy that you then apply when pricing your product. For example, if the production costs of your product are $6, and you want to operate on a 20% profit margin, then you'd need to divide your costs by 0.8 (1 - 0.2, or 20%), meaning that the base price of your product would be $7.50 ($6 x 0.8). If you wanted to operate on a 30% profit margin, you would divide your costs by 0.7 (1 - 0.3, or 30%) and so on.
Choosing your desired profit margin depends on a variety of factors, including standard market rates and what your competitors are charging. You'll also need to make allowances for fixed costs on top of your variable production costs.
5. Divide Your Net Profit by Total Revenue
Finally, to calculate your profit margin, divide your net profit by your total revenue for your selected period. The resulting figure is representative of the percentage of income that makes up your business's profit.
---
Calculating your profit margin is a simple process, but a hugely important one, especially if it is failing to meet (or even exceeding) your desired margin. It is vital to be able to work out and explain quickly to investors and other stakeholders what your profit margin for a particular period was (or is), so it's crucial that you understand how to perform this quick and basic calculation.