What does profit margin mean?

To understand profit, also known as the bottom line, it’s important to understand how it differs from revenue. Revenue, also known as the top line, is all of the income generated by the business’s primary operation. Once expenses and costs are deducted, what’s left behind are the profits. The difference between that top line and the bottom line is the profit margin, which is denoted as a percent. If the top-line number is bigger than the bottom line, that is a net loss. When the bottom line is bigger than the top, that’s net income.

To get profit margins to hit the kind of financial targets that achieve a company’s strategic objectives, organizations need to consider these four factors:

1. Pricing strategy: Adopting a specific pricing strategy is the common step businesses use to achieve margin targets. For companies that want to compete solely on price, success depends on higher volumes. These organizations have to make their costs low enough to continually appeal to the market while selling enough to manage their expenses.
2. Product or service mix: Some products or services may have high profit margins but are sold infrequently, making them low volume. Others may have lower profit margins but sell at higher volumes. Small businesses need to design their offerings to appeal to customers and support their bottom line.
3. Direct and indirect expenses: Being able to control direct and indirect expenses, such as labor, rent and raw materials, gives managers the power to meet their targets through tactics such as discount pricing based on volume.
4. Performance benchmarks: Meeting or exceeding profit margins has a lot of implications for shareholders, board members and senior executives. Better profit margins yield better returns, so periodically monitoring and managing profit margins is in the organization’s interests.

Types of profit margins to measure

When it comes to tracking your organization’s profit margins to improve overall decision-making, there are three categories to consider.

1. Net profit margin

An organization’s net profit margin tells you how much profit each dollar of revenue represents. For example, if your calculations indicate that your net profit margin is 25.2%, that means that for every dollar your business makes, about a quarter is net profit. Net profit margins are barometers of company health. They tell you whether what you’re doing is working and are one of the ways investors assess whether companies are worth their money.

2. Gross profit margin

The gross profit margin is based on the company’s net sales and the cost of goods sold (COGS). Like net profit margin, it’s an indicator of the organization’s overall health but is a more volatile metric that requires additional context. Gross profit margin provides insight into whether the company’s management or product mix is beneficial.

3. Operating profit margin

Variable costs, such as raw materials, also have their own contribution to the organization’s profits. The operating profit margin, sometimes called return on sales (ROS), is a ratio that denotes how efficient the company is at making profits from its sales. It can chart a company’s growth over time, including assessing its management controls, marketing strategies and overall use of resources.

How do you calculate profit margin?

Calculations depend on what type of profit margin metric you’re working with, but in general, you need to know your business revenue, net income and expenses. In all cases, the profit margin formula conforms to the general formula of:

Profit margin = (Net Income/Revenue) x 100

To better understand how each type fits this formula, here are some examples of profit margin calculations you may find useful.

Calculating net profit margin

If you don’t have a number for net income handy, you need to subtract COGS, operating and other expenses, interest and taxes from the revenue to get the net profit margin.

Here’s how to calculate profit margin when your revenue is $10,000, your COGS is $1,000, operating and other expenses are $1,500, interest is $500, and taxes are $700.

Net Income = $10,000 – ($1,000 +$1,500+$500 +$700) = $6,300

Net Profit Margin = ($6,300/10,000) x 100 = 63%

Calculating gross profit margin

If you want to understand more about how a particular product line is doing, calculate the gross profit margin for that line. The total revenue for that line is $1,000, and COGS is $687.

Gross Profit Margin = [($1,000 – $687)/$1,000] x 100 = 31.3%

Calculating operating profit margin

To calculate operating profit margin, you need revenue and operating income. The operating income is earnings before interest and taxes, also called EBIT. For this example, total revenue is $10,000. Operating revenue is:

$10,000 – [$3,750 (COGS) – $2,900 (Other regular expenses)] = $3,350

Operating profit margin = ($3,350/$10,000) x100 = 33.5%

What is considered a good or bad profit margin depends on the business model of the company. While there are industry standard averages that many adhere to, costs of raw materials and labor are subject to fluctuations. To get a more accurate picture of your profit margins, compare yourself to your closest competitors.

Improving your profit margins

If your business’s profit margins aren’t optimal, there are several ways to improve them from the sales and operating sides.

Four ways to increase sales

1. Selling old inventory means making slow movers more visible by moving them to an area with high foot traffic and increased visibility. However, if you simply want to get rid of them, you can sell those items to liquidation companies.
2. Increasing prices is one effective strategy because it contributes directly to profits. In that same vein, you may want to increase your value add. It could be a matter of combining certain products or services that will provide an even bigger benefit to clients who won’t mind paying more.
3. Come up with upselling and cross-selling opportunities. Upselling means persuading customers to buy an upgraded version of what they already have. For example, they bought a six-pack of an energy drink but may be interested in expanding it to 12 or automatically reordering their six-pack periodically. An upsell can be a one-time offer or a subscription service. Cross-selling is about offering a complementary product or service for what they’ve already bought. Someone who has a smartphone, for example, may also be interested in a protective phone case.
4. Go for customer loyalty because it still costs up to 25 times more to acquire a new customer than to keep one. Coming up with a customer loyalty strategy, such as rewards programs or special club membership, is not only a great way to keep customers engaged but it’s also a healthy source of data.

Four ways to reduce costs and expenses

1. Cut what isn’t working. Look within your business and understand where it may have stagnated. Ideas that have been drawing the company down need to be let go.
2. Renegotiate vendor relationships and terms, especially if you know that you are a high-volume customer. Negotiation is an art that can save you money through discounts with suppliers. There may even be opportunities for collaborating with suppliers in joint business planning where both organizations help each other increase profits.
3. Streamlining current processes can include cutting overtime and reducing staff. However, the typical slash-and-burn method is only one option. Automating repetitive tasks, such as bookings and data entry, reduces human resource expenses and can improve productivity.
4. Reduce operating and business expenses. Apart from labor costs, there are a couple of other operating and business expenses businesses can adjust. While raw material costs can fluctuate, cutting down on waste can yield immediate profit margin improvement. Finding ways to reduce the amount of extra material your company buys but doesn’t use within a given period is one method. Another option is cutting utility costs. Installing energy-saving equipment or shutting down idle equipment when not in use are simple ways to reduce your electricity bill. Finally, companies who have the ability to lease or buy used equipment can see immediate savings.

Learning how to calculate profit margins is a vital skill in business. Improving them, however, doesn’t have to be a drastic affair. Many times, small changes make the biggest differences.