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What Is Profit Margin? Definition and Guide

What is profit margin? Definition and guide

It's no secret that in order to run a successful business, you need to turn a profit. But not all profits are created equal.

For instance, if your goal is to make enough money to cover your operating expenses and support yourself as a business owner, then a modest profit will be sufficient. However, if you're interested in expanding your business, hiring more employees, and investing in research and development for your next product line, you'll need profit margins that can sustain the total cost of those objectives over the long term.

In this guide, you'll find the definition of profit margin, explore different types of profit margin, and learn how typical profit margins compare across different industries and businesses.

What is Profit Margin?

Profit margin is the measure of a business, product, service's profitability. Rather than a dollar amount, profit margin is expressed as a percentage. The higher the number, the more profit the business makes relative to its costs.

Businesses with high profit margins

Some businesses and products with higher profit margins include:

  • Luxury goods. Companies producing high-end and specialty products, like apparel, jewelry and watches, cosmetics, and sportscars, tend to have high profit margins. Because brands that make these products have a reputation for luxury, exclusivity, and status, they can afford to mark up their retail prices significantly, helping them turn a significant profit despite lower sales.

  • Software and video games. While game and software developers may spend years perfecting their products, they often enjoy a high profit margin on each copy or license sold thereafter.

  • Pharmaceuticals and medical equipment. Similarly, medical equipment and drug companies spend billions up front on research and development, but are eventually able to recoup those costs by selling patent-protected devices and treatments at a significant profit.

Businesses with low profit margins

Some businesses and products with lower profit margins include:

  • Restaurants: Because they have to contend with a variety of costs, including ingredients, labor, overhead, and rent, restaurants tend to have lower profit margins.

  • Transportation: The high cost of infrastructure, maintenance, and fuel or power keep profit margins low in the transportation sector.

  • Agricultural products: A combination of high inventory and major demands for resources, land, and storage space make agriculture a low profit margin business.

A lower profit margin doesn't necessarily mean that a company isn't making money. On the contrary, most of these businesses compensate for lower profit margins by increasing the volume of customers, products, or materials sold.

Types of profit margin

Small businesses, including retailers, often look at three types of profit margin:

  1. Gross profit margin
  2. Operating profit margin
  3. Net profit margin

What is gross profit margin?

Gross profit margin is a type of profit margin that measures the difference between sales revenue and the costs of goods sold (COGS), which includes direct product expenses like raw materials, packaging, and direct labor (i.e., labor related to manufacturing or selling your products).

To calculate gross margin, start by subtracting the cost of goods sold from net sales. Divide the resulting number into the net sales to get the ratio, which represents the percentage. For example, if sales are $8,000 and costs total $6,000, the difference between the two is $2,000. Divide that difference by sales – $8,000 – and multiply by 100 to get 25 percent. That is the gross profit margin.

When to use gross profit margin

Gross profit margin usually applies to a specific product or line rather than an entire business. Calculating the gross profit margin helps a company determine pricing decisions because a low gross profit could mean that the company needs to charge more to make selling a specific product worthwhile.

What is operating profit margin?

Operating profit margin is similar to gross margin in that it measures revenue against cost of goods sold. However, operating margin also incorporates fixed costs of running your business that aren't directly related to making your products. This includes rent, office supplies, and other administrative costs.

To calculate operating margin, start by subtracting the cost of goods sold (COGS) and administrative expenses from net sales. Divide the resulting number into the net sales to get the ratio, which represents the percentage.

When to use operating profit margin

Operating profit margin can provide insight into how well your business is performing compared to your competitors and peers. The higher your operating margin relative to someone else's, the more efficiently you're managing your expenses.

What is net profit margin?

Finally, net profit margin incorporates all of your business expenses, including COGS, administrative costs, taxes, interest, and depreciation. In other words, this ratio compares net income with sales. Net margin comes as close as possible to summing up the financial health of your business in a single figure.

Calculating the net profit margin is very similar to the steps for gross and operating profit margin, but requires the entire company's revenue and costs. Divide the company's net income (the profit after expenses are deducted from gross income) into total sales, then multiply the result by 100 to get the answer expressed as a percentage.

Let's say gross sales are $150,000 and expenses are $75,000. That means net income is $75,000. Divide that number into gross sales, $75,000 divided by $150,000, to get .50. Multiplying .50 by 100 equals 50 percent, the net profit margin.

When to use net profit margin

Because it provides a snapshot of your business's overall profitability, net profit margin can be especially useful as a metric to share with potential investors. 

Ready for more tips on how to achieve high profit margins for your business? Learn more about increasing your profit margin.

Profit margin FAQ

What does profit margin mean?

Profit margin is the difference between the total cost to run your business and the total revenue it brings in. The higher your profit margin, the more money your business gets to keep.

Is a higher profit margin better?

Generally speaking, a higher profit margin is always better. That said, average margins vary widely across different industries, so take caution when comparing your profit margin to that of another business.

What's a good profit margin for a small business?

While profit margins differ from sector to sector, a good profit margin for online retailers is around 7-8%.

How do I calculate profit margin?

To calculate profit margin as a percentage, divide your company's net income by total revenue, then multiply the result by 100.
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