Whether you’re the head of a multi-million-pound enterprise or run a street food stall, profit margins matter. They signal the financial viability of your business, showing potential investors and partners that you’re in control of profit and loss.
But how do you calculate them, and what exactly is the difference between net profit, gross profit and operating profit? To help, we’ve put together this simple guide explaining the different types of profit margin and how to calculate them.
Profit margin is used to gauge how a business makes money, showing the percentage of revenue which can be classed as profit. This gives a clear picture of how profitable a business is, which can be useful when seeking investment or levelling up.
Profit margin is one of the key indicators of business performance. It clarifies a business’ health, highlighting areas which are profitable and those making a loss.
For every pound a business makes, a percentage of this will (or should) be profit. This is the profit margin. For example, if a business has a 43% profit margin over a given period, this means that 43p in each pound of revenue was profit.
There are several types of profit margin, and each reflects the different costs, taxes and overheads incurred in specific operational areas. Net profit is the most commonly used when assessing profit margin, because it shows how profitable a business is after all other costs are deducted.
When we talk about profit margin, there are four types to be aware of: gross profit, operating profit, pre-tax profit, and net profit. It’s important to understand the differences between these types of profit margin indicators, even if you usually work from net profit alone. That’s because each can help show a business’ financial health, which can be vital in securing loans or outside investment.
Below, we take you through the four types of profit margin and the formulas used to calculate them.
Gross profit is a metric used to calculate the amount of money left after a product or service has been sold. This shows the amount of profit a business makes per sale before other costs and taxes are deducted.
Gross profit is calculated by subtracting the cost of the goods sold (COGS) from net sales, before dividing it by net sales to see the profit margin as a percentage. The formula for this is as follows:
Let’s say a car dealer sells a vehicle for £10,000 but acquired it for £4,000. To calculate the gross profit, subtract £4,000 from £10,000, giving you £6,000. Then, divide £6,000 by £10,000, for a total gross profit margin percentage of 0.6 or 60%.
Operating profit is the profit margin when general and administrative costs are deducted, but not interest costs and taxes. This shows how day-to-day operations and processes affect the bottom line, so it can be very useful in helping to spot inefficiencies and overheads which harm your overall profit margin.
Operating profit is calculated by subtracting all COGS and operating expenses (such as rent, wages, energy bills etc.) from the total revenue, before multiplying the figure by 100% to reach the profit margin percentage. The formula for this is:
Taking the same car dealer as an example, let’s say that selling the £10,000 car incurred an additional £500 in operational costs. To calculate operating profit, add £4,000 to £500 to get £4,500, before subtracting this from the £10,000 in revenue. Now, divide £5,500 by £10,000, for a 0.55 or 55% operating profit margin.
Pre-tax profit is the amount of profit a business makes before taxes and interest are deducted. It can be useful to look at pre-tax profit, particularly when comparing two or more different businesses, as tax and other charges can make it more difficult to see how a profitable a business is.
Pre-tax profit is calculated by deducting all expenses from the total revenue, including operating costs, wages, rent, production overheads, before dividing it by total sales and multiplying the figure by 100, to get to the profit margin percentage figure.
If the car dealer’s total expenses, including COGS, add up to £6,000, this leaves £4,000 in pre-tax profit after selling the £10,000 car. To reach the pre-tax profit margin, divide £4,000 by £10,000 and multiply the answer by 100. In this case, the pre-tax profit margin is 0.4 or 40%.
Net profit is the most significant profit margin metric, and the one businesses, banks and investors generally pay the most attention to. This is because net profit shows how much profit a business comes away with when all other costs, taxes and charges are deducted from their total revenue. Essentially, it’s the amount of leftover money a business has to play with, whether they’re looking to reinvest, save or gives bonuses to their staff, investors or senior stakeholders.
Net profit is calculated by subtracting all associated expenses and overheads from the total revenue generated. To do this, businesses must add together all operating expenses, material costs, interest and taxes, subtract this figure from the revenue, before dividing by the total revenue sum. The formula for this is as follows:
In total, the car dealer makes a net profit of £2,000 after subtracting £6,000 in costs and £2,000 in tax from the revenue generated by the £10,000 car. To reach the net profit margin percentage figure, simply divide £2,000 by £10,000, giving you 0.2, before multiplying by 100. In this case, the net profit margin for this revenue is 20%.
For every size and type of business, profit margins are hugely important in highlighting profitability and financial performance. These figures are used to give a top-line look at a business’ profit potential – which is crucial for investors and banks seeking to make a decision on whether to lend a business monetary funds.
But profit margins can be used for more than just attracting investment and highlighting company performance. From an operational perspective, they’re useful for tracking seasonal sales patterns, unnecessary overheads and other factors which may be placing undue strain on the business’ profitability. By periodically checking all types of profit margins, businesses can stay abreast of any and all changes and trends which can affect their performance and growth.
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Growth Stories: Hassan Mohamed, Harrison Forbes Consultancy
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