How to Calculate Profit Margin: Formulas & Types

What are profit margins?

Profit margins are the percentage of revenue retained after covering costs.
They represent your company’s operational efficiency and growth, depending on the type of profit margins you’re looking at.

It’s one of the most critical metrics investors look at before investing in a company. Profit margins also have a major impact on your company’s valuation.

Types of profit margins

There are three types of profit margins, each providing unique information about a company’s profitability. All three types of profits appear on a company’s income statement.

Here’s Apple’s income statement for example:

Let’s look at each one in the order they appear in the income statement.

Gross profit margin

Gross profit margin is the percentage of revenue retained after accounting for the cost of goods sold (COGS), or cost of sales if you’re a service company.

The COGS or cost of sales includes all costs incurred directly to make the product sellable or render the service. If you’re a retailer, the COGS includes all expenses incurred until the product reaches your warehouse (including shipping and taxes).

To improve gross profit margin:

• Negotiate a better price with vendors
• Find ways to lower shipping costs
• Increase the price
• Lower your labor and overhead costs (if you manufacture the products you sell)

Operating profit margin

Operating profit margin is the percentage of revenue retained after accounting for operating expenses but before interest and taxes.

It’s a gauge of your company’s operational efficiency and cost structure, which include costs like salaries, rent, and utilities. Interest and taxes are excluded because they’re not operating expenses.

Operating expenses are costs that your business incurs during the normal course of business to keep the business running. That’s why operating expenses don’t include the following costs:

• Direct costs: Costs that aren’t tied directly to the production of goods or the rendering of services. These go under the COGS or the cost of sales.
• Non-operating costs: Non-operating gains and losses such as gain or loss on the sale of assets like equipment, real estate, or marketable securities and one-off events like losses from natural disasters are excluded.
• Financial and regulatory costs: Interest, taxes, restructuring costs, foreign exchange losses, and impairment losses are excluded.

Earnings before interest and taxes (EBIT) is often used interchangeably with operating income. The two are often, but not always, the same. EBIT may include non-operating income such as earnings from investments or sale of assets before interest and taxes. If you’re using EBIT, subtract or add any non-operating gains or losses to calculate the operating income.

Here are some ways to improve your operating margin:

• Increase price or revenue: Unlike COGS, which is variable, many operating expenses, such as salaries, are fixed. If you’re able to generate higher revenue while keeping costs unchanged, your operating margin increases.
• Improve inventory management: Use inventory management software to reduce excess inventory, which leads to higher storage costs as well as spoilage, obsolescence, and shrinkage.
• Reduce operating expenses: Reduce headcount, cut unnecessary operating expenses like expensive office space, or outsource functions like IT and customer support to lower operating costs.

Net profit margin

Net profit margin is the percentage of revenue retained after accounting for all expenses.

It’s a critical metric because it has a major impact on your company’s valuation, cash flow, book value of equity, dividends, and growth.

Net profit margin isn’t always the best gauge for a company’s performance, though. Think about loss-making startups. Investors pour billions of dollars into loss-making startups every year even though they have a negative net profit margin.

The largest companies you know were loss-making when they started:

• Apple made its first profit two years after it was founded
• Intel recorded its first profit three years after launching its first chip (the DRAM)
• Facebook turned profitable in 2009, five years after it was founded

The reason for a negative net profit margin is often a high interest expense. These companies need debt to support growth, which turns their bottom line negative. However, if they’re operationally profitable, investors might consider buying their equity.

To improve net profit margin:

• Improve operating profit margin: If you’re not generating a profit from operations, your chances of survival are slim. If you’re generating an operating profit, increase it further to increase your net profit using methods discussed in the previous section.
• Lower your debt: If you have enough cash on hand, pay off some debt to lower your interest expense and increase your net profit margin. It may be smarter to stay financially leveraged if you’re in a high growth phase and don’t have cash flow problems but this may or may not be true depending on your specific financial circumstances.
• Do some tax planning: Ask the CFO to investigate ways to lower your tax liability. If you’re able to lower your income tax expense, you can increase your net profit margin.

How do you calculate profit margin?

You calculate profit by subtracting expenses from revenue. However, the expenses you subtract depend on the type of profit you want to calculate.

Let’s discuss how you can calculate various types of profit.

Data you’ll need to determine profit margin

All the data you need can be sourced from the company’s income statement or financial software. Here’s what you need:

• Total revenue
• COGS
• Operating expenses
• Non-operating gains and losses
• Interest
• Taxes

How to calculate gross profit margin

To calculate the gross profit margin:

• Calculate gross profit: Subtract the COGS or the cost of sales from revenue.
• Calculate gross profit margin: Divide gross profit by revenue and multiply it by 100.

For example, suppose your revenue is $100,000 and the COGS is $30,000, your gross profit margin would be 70%.

Gross profit margin formula

(Gross Profit / Revenue) x 100 = Gross Profit Margin

In our example, the calculation would look like this:

(($100,000 – $30,000) / $100,000) x 100 = 70%

How to calculate operating profit margin

To calculate the operating profit margin:

• Calculate the gross profit: Start with the gross profit directly or calculate it by subtracting the COGS or the cost of sales from revenue.
• Subtract operating expenses: Subtract operating expenses from gross profit. Exclude non-operating expenses, interest, and taxes. This gives you the operating profit.
• Calculate operating profit margin: Divide operating profit by revenue and multiply it by 100.

Suppose your gross profit is $70,000 and operating expenses are $35,000. Your operating profit margin would be 35%.

Operating profit margin formula

(Operating Profit / Revenue) x 100 = Operating Profit Margin

(($70,000 – $35,000) / $100,000) x 100 = 35%

How to calculate net profit margin

To calculate your net profit margin:

• Calculate the operating profit: Start with the operating profit directly or subtract operating expenses from revenue to calculate operating profit.
• Subtract non-operating expenses: All expenses that haven’t been subtracted from the revenue until this point, including interest, taxes, and other non-operating expenses such as restructuring costs or losses caused by a natural disaster. This gives you the net profit.
• Calculate net profit margin: Divide net profit by revenue and multiply it by 100.

Suppose your operating profit is $35,000 and the sum of non-operating expenses, interest, and taxes is $10,000. Your net profit margin would be 25%.

Net profit margin formula

(Net Profit / Revenue) x 100 = Net Profit Margin

(($35,000 – $10,000) / $100,000) x 100 = 25%

How to improve your profit margins

We briefly touched on ways to improve profit margins earlier, but let’s dive deeper and talk about actionable steps you can take to improve profit margins.

A quick scan of your income statement will help you see that there are two types of levers to influence profit margins—revenue and costs. If you can increase your revenue or reduce your costs, your profit margins will increase.

With that in mind, let’s dive into specific strategies to improve profit margins.

1. Understand your product costs

Product costs are the most powerful lever of profitability because they typically make up the biggest portion of your cost structure.

Professor Aswath Damodaran, who teaches corporate finance and valuation at the NYU Stern School of Business, maintains a frequently updated list of profit margins across industries in the US. Most product-based businesses have a profit margin below 30%, which translates to a 70% COGS.

Understanding and tracking your product costs can help you identify costs you can potentially reduce. Manufacturers have more complex direct cost structures, but even trading businesses incur various product costs other than the product’s purchase price. If you’re a trading business, you might incur carrying costs such as:

• Storage costs
• Cost of capital
• Cost of obsolescence, theft, and damage

If you’re a manufacturer, you incur carrying costs and production costs, such as:

• Direct materials
• Direct labor
• Variable costs (such as electricity needed for production)
• Fixed costs (such as factory rent or machinery depreciation expense)

The only realistic way to do that is by using inventory software. Here’s how inventory management software can reduce product costs for trading and manufacturing businesses:

• Demand forecasts: Accurate demand forecasts help minimize carrying costs. It’s a little more tricky to manage carrying costs for manufacturers because they have fixed costs such as factory rent. Lower production activity leads to higher fixed costs per unit and diminishes the positive impact of reduced carrying costs, so it’s important to do a cost-benefit before choosing to not operate at optimal capacity.
• Batch and serial number tracking: Assign batch and serial numbers to parts and finished products to trace them using inventory software and optimize for efficiency.
• Supplier management: Inventory management can integrate suppliers to help you streamline procurement processes and minimize procurement costs. It also helps track supplier performance. Use this information to build stronger relationships with partners that are more efficient and reliable.
• Bill of materials management: Track key components and raw materials required for assembly or product to avoid overstocking and prevent theft.

If you’re looking for comprehensive inventory management, try Unleashed for free today without our risk-free, 14-day trial. If you need more information on understanding how Unleashed can help your business, book a call.

2. Evaluate other indirect costs

Other indirect costs such as commissions to sales agents, salaries of administrative staff, and depreciation on office furniture can also impact profitability. They don’t affect your gross margin because they’re not directly related to the product, but can help improve your operating and net income.

To use indirect costs as a lever for profitability:

• Improve operational efficiency: Optimize operational efficiency to minimize operating costs. For example, instead of hiring three bookkeepers and a manager to track inventory and place orders, use inventory management software to automate the process, improve the efficiency of inventory processes, and reduce salary expenses.
• Reduce operating expenses: If your income statement shows plenty of unnecessary operating expenses or if you’re strapped for cash, focus on reducing operating expenses. Consider downsizing your office, selling dead stock at a discount, or skipping the annual employee trip for a year or two.

Information about operating expenses is available on your income statement. Go to the notes to financial statements to get a more detailed list of operating expenses you can optimize or reduce.

3. Increase your topline

Greater revenue translates to increased profits in absolute terms. However, the impact on profit margins depends on the strategy you use to increase your topline. Here are two ways you can increase revenue:

• Increase the price: Increasing your price increases your revenue and impacts all profit margins—gross, operating, and net. Assuming the marginal price is all profit (and there has been no increase in costs or tax rate), it will trickle down as profit to your gross profit and operating profit as it is and will be added post-tax to your net profit.
• Sell more: If you keep the price as is and manage to sell more units, your gross margin won’t change. Your operating and net margin will increase as long as your operating expenses include at least some fixed costs (which they likely do).

Let’s take a look at how this works:

Profit margins in bold are ones that increased because you either sold more or sold the same number of units at a higher price.

4. Pay off debt

Interest on debt is a fixed cost. Regardless of how much you sell or how efficiently you operate, you pay the same interest amount every year as long as the principal of your loan remains the same.

Paying off debt or refinancing existing debt with one that charges a lower interest rate reduces the interest expense and increases your net profit margin (not gross or operating profit margin). It doesn’t always make sense to pay off debt, though. Here are some ideal scenarios where repaying debt could be a smart decision:

• You have excess cash: Your business needs cash for day-to-day operations and growth. However, if you expect economic uncertainty and have limited growth potential, you might consider paying off debt, provided you have enough cash.

Fun fact: Borrowing money can also improve profitability.

Think about it. If your industry is booming, you can deploy cash towards gaining market share (and sell more units) or building production capacity (to fuel growth, and by the same token, sell more).

These strategies typically generate a higher return than the cost of debt—for most companies, the contribution margin percentage is greater than the marginal cost of debt, which means taking on debt can improve your operating and net profit margins.

• You can refinance at a lower rate: If you have high-interest credit lines or term loans, go window shopping and see if lower-rate options are available. A lower interest rate translates to a lower interest expense and improves your net profit margin. It’s easier to find cheaper debt if the repo rate has dropped since you last borrowed money.

5. Plan your taxes

You need a tax consultant to plan your taxes. If you’re not a CPA or a trained tax professional, there’s little chance that you’ll successfully minimize your income tax liability. However, here are some techniques you can discuss with your tax advisor:

• Tax credits: The IRS allows businesses to claim tax credits. For example, you can claim tax credits for R&D, investing in energy-efficient equipment or vehicles, and offering work opportunities to individuals from targeted groups who face barriers to employment.
• Tax-deferred retirement plans: Contributing to 401(k) or Simplified Employee Pension plan (SEP) contributions to an Individual Retirement Account or Annuity (IRA) reduces taxable income. If you have a stable cash flow, consider setting up a defined benefit plan, which can allow for higher annual contribution limits and greater tax deductions.
• Take advantage of deferrals: If your cash flow allows, accelerate expenses into the current year and defer revenue to the next. Use options like the 1031 exchange rule to defer capital gains on real estate and preserve cash flow. According to the Internal Revenue Code Section 1031, you can get a tax break that allows deferring capital gains on investment property if you purchase a similar replacement property (called a “like-kind” property).
• Change inventory valuation method: You can switch from FIFO (First-In-First-Out) to LIFO (Last-In-First-Out) during inflationary periods or vice versa to increase your COGS. Note that this will reduce your net profit margin for the current year, but increase it in the future years when you expense inventory at old prices. You might also consider writing down your inventory if it has lost value over time, but remember to stay compliant with IRS rules for valuation adjustments.

These are some of the many strategies you can use to minimize your tax liability. Speak with your advisor to get advice specific to your situation.