Profit margin is a key financial metric that can instantly tell you how well or poorly your business is doing. It looks at the difference between your revenue and expenses and expresses that difference as a percentage of revenue.
While you should know the profit margin for your company as a whole, it’s very important to evaluate each area of the business separately. This will provide tremendous insight into your various offerings. In this guide, we’ll discuss the different types of profit margins, how to calculate your margin, and strategies to improve it.
Profit margin formulas
You can compute margins for your business from gross profit, net profit, or operating profit.
- Gross profit margin is a percentage ratio of revenue your business keeps after deducting all direct costs. This margin indicates how successful your company is at making money and minimizing its expenses.
- Net profit margin is a profitability ratio (expressed as a percentage) that measures a business’s net profit for each dollar of revenue earned. For example, a 10% profit margin in your business means that for each $1 of revenue, your company earns $0.10 in net profit.
- Operating profit margin is a profitability ratio that measures a business’s ability to generate operating profit from each unit of revenue earned. It can help you determine if your company is effectively controlling its operating costs.
How to calculate gross profit margin
The formula for gross profit margin is:
Gross Profit Margin = Gross Profit / Revenue x 100
To calculate the gross profit margin, you must first calculate the gross profit. Gross profit is the money your business makes after accounting for the direct cost of goods sold (COGS) and services, like materials and labor. It’s calculated by deducting the cost of goods sold or services from revenue (sales).
When you deduct the costs of the above products and services from the revenue they bring in, you’ll get the gross profit. Once you know your gross profit, you can calculate the gross profit margin with the formula above.
For example, if you run a gym, your revenue comes from services like nutritional counseling, personal training, group fitness classes, and massage therapy. The costs directly associated with these services include wages for trainers and therapists, and massage supplies like oils, candles, and creams. You might also sell products like protein powders, nutritional supplements, gym apparel, and water bottles.
How to calculate operating profit margin
The formula for operating profit margin is:
Operating Profit Margin = (Operating Profit / Revenue) x 100
Operating profit is also known as operating income or earnings before interest and tax (EBIT). It’s the money that a company has left after covering its operating costs (gross profit minus operating expenses) but before paying its taxes and interest charges.
Operating costs include rent, maintenance, utilities, salaries and benefits, depreciation, and amortization. To calculate the operating profit margin, divide the operating profit by the total revenue and multiply by 100.
How to calculate net profit margin
The formula for net profit margin is:
Net Profit Margin = (Net Profit / Revenue) x 100
You must first calculate the net profit or net income to get your net profit margin. Net profit helps you evaluate the financial performance of your business and is a significant indicator of its profitability. Net profit is the money your business makes after deducting all expenses, including COGS, taxes, discounts, interest, operating costs, and depreciation, from total earnings.
For example, your gym from the previous example may also spend money on rent, utilities, equipment, marketing, interest on loan payments, and certification fees. After deducting all these expenses from the revenue, you’ll get the net profit. Divide the net profit by the total revenue and multiply by 100 to get the net profit margin.
Calculating profit margin example
We'll go through an example of how to calculate net profit margin in four simple steps.
Step 1: Calculate revenue
This sales, or revenue, number could be the sales of a particular product, like yoga mats, or a certain service, like haircuts or massage. Both Mindbody and Booker offer Sales by Category reports that can easily provide this information. If your report includes sales tax, you will need to deduct it from your total sales since tax is not a true source of income.
Example: Assume a studio offers yoga classes and sells yoga mats. From their sales reports, we learn that they earned $3,000 from classes and $400 from the sale of 20 yoga mats last month.
Step 2: Calculate the costs associated with sales
The key in this step is to identify the direct costs that are required in order to generate each sale. These are often referred to as cost of goods (or services) sold.
The direct cost for the yoga mats is the amount the supplier charges. If the supplier adds a fee for shipping, we would include that too. In this example, the supplier charges $15 per mat + $100 for shipping all 20 mats for a total cost of $400.
For appointment-based services or classes, we would use the direct expenses associated with the person providing the service. These expenses could include payroll, payroll taxes, benefits, and commissions. For this studio, the total monthly payroll cost for the yoga instructors is $2,000.
If a service requires products—for example,essential oils for towels—you would include the costs of the supplies used to perform the service as well.
Note: You would not include fixed operating expenses like rent, utilities or insurance in these calculations because they do not change based on how much you sell. Instead, fixed operating costs would be included when calculating the profit margin for the business as a whole.
Step 3: Subtract costs from revenue to get your profit
In this example, our profit would be:
Yoga Classes
$3,000 (revenue) - $2,000 (payroll) = $1,000 profit
Yoga Mats
$400 (revenue) - $400 (cost) = $0 profit
Step 4: Divide the profit by the revenue and multiply by 100 to get your profit margin
The resulting percentagewould be the profit margin.
Yoga Classes
$1,000 profit / $3,000 revenue x 100 = 33.3% profit margin
Yoga Mats
$0 profit / $400 revenue x 100 = 0% profit margin
If we only looked at total sales, the studio appears to be profitable. Evaluating these items separately allows us to identify that the studio is not earning any profit on the sale of the yoga mats. Even if the studio sold 10 times the amount of yoga mats, they would still make no profit because their COGS and sales for mats is the same.
Tracking margins will help you identify pricing errors, management problems, or accounting issues. Margins will show you areas of excess spending, your biggest money makers, and which items are underperforming. Understanding your profit margin is an invaluable tool when it comes to growing your business.
What is a good net profit margin?
As a general guideline, 20% is a good net profit margin, 10% is considered average, and 5% is low; however, this isn’t set in stone. Every industry has different profitability guidelines, so a good net profit margin for your business might be below 20%.
For example, a margin of 8-10% is an acceptable standard for the salon industry, considering the high costs involved and its competitiveness. Other factors to consider for your business include company size, economic conditions, geographic location, and customer trends.
A high net profit margin usually means that the business is making good money and controlling its expenses. A lower net profit margin means the business needs to reconsider its pricing strategy and costs and better manage its revenue structure.
How to improve net profit margin
Having a good net profit margin has several benefits, including long-term profitability for your business. Here are some tips on improving your net profit margin:
- Track everything. Know the costs associated with producing your revenue. Once you know these costs, you can manage them.
- Increase your service/product offerings. Adding additional offerings may help boost your profit margin as long as these new offerings are profitable.
- Cut underperforming services. Recognize quickly if something is unprofitable. While some items may take time to “catch on,”—don’t wait indefinitely for that to happen.
- Increase pricing. By increasing the sales price of your products, you can increase your profit margin. Ensure that you’re following pricing best practices for your industry.
- Decrease expenses. The quickest way to improve your bottom line is by decreasing expenses. Every dollar saved adds directly to your profit and your pocket.
- Build strong relationships with customers. By providing excellent customer care, being transparent, and soliciting customer feedback, you can increase your customers' loyalty and encourage them to spread the word, leading to higher revenues.
- Build a strong brand. A strong brand involves having a unique selling proposition (USP), a strong online presence through social media, and a website that will attract a wide range of leads.
Calculate your profit margin for long-term success
Knowing how to calculate margins in your business will help you spot potential issues before they hurt the bottom line. Once you know how to compute your margins, work on improving them so that your business stays profitable and sustainable for the long term.
Another way you can increase your profit margins is by partnering with Mindbody. Our platform gives you access to more customers, driving more revenue for your business. It’s your perfect partner for running everyday tasks like motivating your team, marketing your business, and managing bookings efficiently.
