How to Determine Profit Margins: The Ultimate Guide

Are you a small business owner looking to increase your profits? If so, you need to know how to determine profit margins. Profit margins are the percentage of revenue that a company keeps as profit after accounting for all expenses. In order to increase profits, you need to either increase revenue or decrease expenses. However, before you can do either of those things, you need to know your current profit margins. Keep reading to learn how to calculate them.

How to Calculate Profit Margins: More Than One Way to Skin a Cat

There are a few different ways to calculate profit margins. The method you use will depend on the type of business you have and the data you have available. The most common methods are: gross margin, operating margin, and net margin. Let's take a closer look at each one.

Gross Margin Method

The gross margin method is the most basic way to calculate profit margins. To use this method, simply subtract the cost of goods sold (COGS) from total revenue. Then, divide that number by total revenue and multiply by 100 to get a percentage. Here's the formula:

[(Total Revenue - Cost of Goods Sold) / Total Revenue] x 100 = Gross Margin Percentage

For example, let's say your company had $100,000 in sales last year and spent $60,000 on COGS. Using the formula above, we would calculate the gross margin percentage like this:

[($100,000 - $60,000) / $100,000] x 100 = 40%

This means that your company had a 40% gross margin last year.

While on the surface 40% profit margin seems like a great outcome, you'll see quickly once we dive into operating margins and net margins that it may be misleadingly high. Let's get into operating margins.

Operating Margin Method

The operating margin method is similar to the gross margin method, but it also takes into account operating expenses. Operating expenses are all the costs associated with running your business that aren't related to COGS. This includes things like rent, utilities, administrative costs, etc. To calculate operating margin, simply subtract operating expenses from total revenue before dividing by total revenue and multiplying by 100. Here's the formula:

[(Total Revenue - Operating Expenses) / Total Revenue] x 100 = Operating Margin Percentage

For example, let's say your company had $100,000 in sales last year and spent $60,000 on COGS and $20,000 on operating expenses. Using the formula above, we would calculate the operating margin percentage like this: [($100,000 - $60,000 - $20,000) / $100,000] x 100 = 20%. This means that your company had a 20% operating margin last year.

After taking into account operating margins, our overall profit margins were cut in half. Pretty startling compared to seeing just our gross profit margins. Yet, the operating margin method still isn't the most ideal measurement for figuring out true profit margins. For that, let's dive into net margins.

Net Margin Method

The net margin method is the most accurate way to calculate profit margins because it takes into account all expenses—not just COGS and operating expenses but also things like taxes and interest payments. To calculate net margin, subtract all expenses from total revenue before dividing by total revenue and multiplying by 100. Here's the formula :

[(Total Revenue - All Expenses) / Total Revenue] x 100 = Net Margin Percentage.

For example , let's say your company had $100,000 in sales last year, spent $60,000 on COGS, $20,000 on operating expenses, $5,000 on interest payments, and $5,000 on taxes . Using the formula below we would calculate the net margin percentage lite this : [($100,000- $60,000 - $20,000 - $5,000 - $5,000) / $100,000] x 100= 18%.

This means that your company had a net margin of 18% last year.

You can see how if we were to operate our budget off 40% gross profit margins believing that to be our true profit margin how we might quickly slip into making poor financial decisions.

While not the most sexy of topics, understanding your true profit margins is one of the most important metrics for you as a small business owner to know.

Now that you know how to calculate profit margins using the gross margin, operating margin, and net margin methods you can start to increase your company's bottom line .

Whether you choose to increase revenue by growing your sales force or decreasing expenses by cutting costs you need to know your current profit margins in order for you to make the most informed decisions possible. Calculating your profit margins can seem daunting at first but with a little practice you'll be a pro in no time!

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