# Profit Margin

Profit margin is an accounting ratio that shows a company's profit as a percent of revenue. Learn to calculate and review gross, operating, and net profit margin.

## What is a Profit Margin?

Profit margin is the amount of profit relative to net sales. The ratio shows you how well a product’s sales or a company’s overall sales cover their costs.

Margins are always expressed as percentages, whereas profit itself is expressed in U.S. dollars or other currency.

There are several profit margins that can be calculated, such as gross profit margin, operating profit margin, and net profit margin. All of these calculations rely on comparing different views of profitability to a company’s revenue.

In particular, various business stakeholders will look to see if the profit margin ratio has been steady over several accounting periods. It can be a worrying sign if profit margin is declining or going negative (the company is losing money) without a clear explanation as to why.

## Profit Margin Definition

Profit margin is the percent of profit compared to revenue. Here is the simplest profit margin formula:

Profit Margin = Profit / Revenue In this section, we will define the different profit margin types and provide formulas for each.

### Gross Profit Margin

The gross profit margin ratio is gross profit divided by revenue. Gross profit is revenue less cost of goods sold, which refers to direct labor, direct material, and other direct costs needed to generate sales.

Gross Profit Margin = Gross Profit / Revenue

This ratio is also called gross profit margin or gross margin. Gross margin is important because it shows how well a company can cover its variable costs.

The only way to improve gross margin is to decrease the cost of goods sold relative to revenue.

### Operating Profit Margin

The operating profit margin ratio is operating profit (EBIT) divided by revenue. Operating profit is revenue less cost of goods sold (COGS) and operating expenses (OPEX). OPEX refers to indirect costs, like rent, payroll, marketing, insurance, lawyer fees, and more.

Operating Profit Margin = Operating Profit / Revenue

This ratio is also called operating profit margin or operating margin. Operating margin is important because it shows whether a company can cover its ordinary expenses.

You can improve operating margin by decreasing COGS or OPEX.

### Net Profit Margin

The net profit margin ratio is net profit divided by total revenue. Net profit (also called net income or bottom line) is total revenue less total expenses, including non-operating revenues and non-operating expenses.

Net Profit Margin = Net Profit / Total Revenue

This ratio is also called net profit margin or net margin. Net margin is important because it highlights if a business can cover all of its expenses. You can improve net margin by decreasing cost of goods sold, operating expenses, and non-operating expenses like interest and taxes.

All of these values – revenue, cost of goods sold, gross profit, and so on – are found on a company’s income statement.
In the section on related profitability metrics, we will talk about financial metrics that compare profit to values found on the balance sheet.

## Profit Margin Examples

Now that we have explored all three types of profit margin calculations, let’s work through some examples. In this example, we will calculate gross, operating, and net profit margin for two years given the consolidated income statements below.

Company A, Fiscal Year 2020

• Revenue: \$250,000
• COGS: \$88,000
• Gross Profit: \$162,000
• OPEX: \$97,500
• Operating Profit: \$64,500
• Non-Operating Revenue: \$0
• Non-Operating Expenses: \$0
• Net Profit: \$64,500

Company A, Fiscal Year 2021

• Revenue: \$390,000
• COGS: \$153,000
• Gross Profit: \$227,000
• OPEX: \$180,000
• Operating Profit: \$47,000
• Non-Operating Revenue: \$0
• Non-Operating Expenses: \$5,000
• Net Profit: \$42,000

Let’s use the formulas above, starting with fiscal year (FY) 2020.

Gross Profit Margin = Gross Profit / Revenue

GPM = \$162,000 / \$250,000

GPM = 0.648

GPM = 64.8%

Operating Profit Margin = Operating Profit / Revenue

OPM = \$64,500 / \$250,000

OPM = 0.258

OPM = 25.8%

Net Profit Margin = Net Profit / Revenue

NPM = \$64,500 / \$250,000

NPM = 0.258

NPM = 25.8%

Note that since there was no non-operating income or expenses that there was no difference between the margins for operating profit and net profit.

Now let’s do the same for FY2021.

Gross Profit Margin = Gross Profit / Revenue

GPM = \$227,000 / \$390,000

GPM = 0.582

GPM = 58.2%

Operating Profit Margin = Operating Profit / Revenue

OPM = \$47,000 / \$390,000

OPM = 0.1205

OPM = 12.1%

Net Profit Margin = Net Profit / Revenue

NPM = \$42,000 / \$390,000

NPM = 0.1077

NPM = 10.8%

Note that we took some of the intermediary calculations to four decimal points in order to round correctly. For instance, 0.1205 rounds to 0.121 which can be expressed as 12.1%.

Across the board, Company A’s margins declined from 2020 to 2021. What other information can you learn by comparing the data from the two years?

## Related Profitability Metrics

In addition to calculating these margins, stakeholders should look at other views into the profit that a business is generating. We recommend tracking:

• Return on assets (ROA)
• Return on equity (ROE)
• Return on invested capital (ROIC)

### Return on Assets (ROA)

Return on assets (ROA) is a profitability ratio that compares a company’s profitability to total assets, which is found on a company’s balance sheet. This is a measure of efficiency, as it is better for a business to generate more profit from fewer resources.

The return on assets formula is:

ROA = Net Profit / Average Total Assets

ROA is expressed as a percent and the higher the number, the more efficient the company is being run. You can calculate ROA for the month, quarter, or year. It’s important to look at average assets for the calculated period, as the levels can vary considerably throughout the period.

Remember that net profit and net income are the same thing, and can be used interchangeably in this formula.

### Return on Equity (ROE)

Return on equity (ROE) is a profitability ratio that compares a company’s profitability to total shareholders’ equity. Shareholders’ equity is found on a company’s balance sheet. This is a measure of efficiency, as it is better for a business to generate more profit with less equity investment.

The return on equity formula is:

ROE = Net Profit / Average Shareholders’ Equity

ROE is expressed as a percent and the higher the number, the more efficient the management is at running the business. You can calculate ROE for the month, quarter, or year.

It’s important to look at average equity for the calculated period, as companies can raise money and change their equity balance throughout the period.

### Return on Invested Capital (ROIC)

Return on invested capital (ROIC) is a profitability ratio that compares a company’s profitability to the total invested capital. The total invested capital is the sum of debt and equity, both of these accounts are found on a company’s balance sheet. This is a measure of efficiency, as it is better for a business to generate more profit with less overall investment.

The return on equity formula is:

ROIC = Net Profit / (Average Total Debt + Average Shareholders’ Equity)

ROIC is expressed as a percent and the higher the number, the more efficient the management is at running the business. You can calculate ROIC for the month, quarter, or year. It’s important to look at average invested capital for the calculated period, as companies can raise money and change their debt or equity balance throughout the period.

Changes in either debt or equity will influence this ratio. For example, raising additional equity will lower your ROIC while paying off debt will increase your ROIC.

## Final Thoughts

Profit margin is an important financial metric that is important to track, whether you are a small business serving your hometown or a global corporation. Small business owners, executives, managers, investors, and lenders all look to profit margin as a sign of business health.

In particular, stakeholders will look to see if the profit margin ratio has been steady over several accounting periods. When discussing profit margin, it’s important to clarify whether you are referring to gross profit margin, operating profit margin, or net profit margin.

Here are the key takeaways:

• Gross profit margin refers to gross profit divided by revenue. Gross profit is revenue less COGS.
• Operating profit margin refers to operating profit divided by revenue. Operating profit, also called earnings before interest and taxes (EBIT), is revenue less COGS and OPEX.
• Net profit margin refers to net profit divided by revenue. Net profit is total revenue less total expenses, including non-operating revenues and non-operating expenses.

Profit margin is a type of profitability ratio, which shows how much profit a company is making. Other examples include ROE, ROA, and ROIC. These metrics track profitability against the company’s resources.

As a result, a “good” profit margin number is largely dependent on the type of business, company stage, and business strategy.

For example, a company might pursue a low price strategy in order to gain market share, which would mean that they intentionally keep their selling price low. This would lower their profit margin compared to another business with a different plan.

A markup is closely related to margin, but they are not the exact same. Gross margin is the ratio of profit relative to the sale price, whereas markup is the ratio of profit relative to the purchase price.

If a retail business purchased shoes for \$60 and sold them for \$100, they make \$40 of profit for each shoe that they sell. This \$40 represents a 67% markup and a 40% gross profit margin. It’s important to note that a markup can exceed 100% while a gross margin cannot be.

Lastly, profit margin is often used to compare competitors in the same industry.

For example, in Q4 2020, Apple made \$12.67 billion of profit on \$64.70 billion of net sales. Their net profit margin was 19.6%. Whereas, Microsoft made \$11.2 billion of profit on \$38.0 billion of net sales. While their overall profit was lower, their net margin was much higher at 29.5%.