Provide any two values to calculate the rest.
When you run a small business or work as an entrepreneur or freelancer, you aim to make a profit. It means your business’s revenue must cover the total costs and leave you with some money in the bank. However, there are many factors to consider, such as production costs, distribution costs, selling prices, taxes, interest, and so on. All these are part of the profit margin calculation. Each financial decision you make gravitates around profitability, which is why understanding what profit margins are and how to calculate them is the first step toward building a business of any type and size. So read along to find out why profit margins are important, practical examples, and answers to all your questions regarding this topic.
Profit margin is a metric that represents how much of the revenue (e.g., the total amount of money your business makes from selling products or services) remains after you deduct all costs (e.g., the total amount of money you spent to have a product or service to sell). The metric is calculated in percentages.
Profit margins, as well as the factors that contribute to achieving good profit margins, may vary across different industries. Terminology may also slightly differ. However, the most common types of profit margin are gross margin, net profit margin, and operating profit margin. You’ll bump into them whether you’re a freelancer trying to set up the price list or a small business looking to navigate the market efficiently. The formulas may differ, but the main idea is the same, and so knowing the basics will get you through all margin types.
The basic profit margin formula is the following:
Profit Margin (%) = (Revenue-Costs)/Revenue*100
Where Revenue represents the total income generated by sold goods, and Costs represents the total cost of goods sold (COGS).
However, different types of profit margins work with varying types of revenues and costs.
Gross profit margin considers revenue, the total of all sales, regardless of deductions, such as returns, allowances, and sales discounts, which means the formula for gross profit margin looks like this:
Gross Profit Margin (%) = (Gross Sales-COGS)/(Gross Sales)*100
The net profit margin represents the percentage of total revenue that becomes income after deducting expenses and taxes. It doesn’t consider the costs of production, distribution, and so on.
Net Profit Margin (%) = (Net Income)/Revenue*100
To determine the profitability of your business, you need to calculate the operating profit margin. The operating profit margin considers everything and shows you how much money your business makes by comparing the operating income with the net income. The operating income represents the total amount of money left after subtracting all expenses from the gross income:
Operating Income= Gross Sales-Deductions-Taxes-COGS-Wages-Interests
The operating profit margin formula is:
Operating Profit Margin (%) = (Operating Income)/(Net Income)*100
Let’s take the gross margin formula and apply it to a practical case. So, the gross profit formula is:
Gross Profit Margin (%) = (Gross Sales-COGS)/(Gross Sales)*100
Begin by determining the costs associated with the production, distribution, and sales of your products. This should encompass all expenses, including wages, raw materials, marketing, electricity, and other relevant costs. This total is known as your cost of goods sold (COGS). For example, if you manufacture and sell 100 items, and your COGS totals $1,000.
Then, find out the total amount you sell these goods for. For instance, the selling price for one good is $20, and you sold all of them, so the gross sales at the end of the month are $2,000.
Fill in the data in the gross profit margin formula:
Gross Profit Margin (%) = ($2,000-$1,000)/$2,000*100=50%
Congratulations! You’ve made a profit.
However, profit margins shouldn’t be left to chance. Instead, you should use them to calculate expected revenue and selling prices to ensure you have a profit at the end of the month. Let’s say you want a gross profit margin of 30% and estimate costs of $1,000. In this scenario, the gross sales goal is at least:
Gross Sales = (COGS*100)/(100- Gross Profit Margin)= ($1,000*100)/(100-30)=$1,428.57
At this point, the decision you have to make is whether you try to sell at least half of your production at a higher price (e.g., $20) or your entire production at a lower price (e.g., $15). Which takes us to the issue of calculating prices using margins.
Let’s say you know the industry standard margin and want to calculate the selling price that will help you achieve it. You are aware of the production and distribution costs, as well as taxes and all other expenses that contribute to the overall cost. To calculate the selling price of a product or service, use the formula:
Selling Price = Cost/(1- Margin)
For instance, according to fullratio.com, the average gross profit margin for the computer hardware industry is 35.4%. This means your selling price should be:
Selling Price = Cost/(1- 0.354)=1.55*Cost
Margins also help you manage costs and make informed decisions for your production, distribution, and other fees. To remain competitive, you need to keep the selling price in line with that of your competitors. You can’t sell a cup of coffee for $50 when everybody else is selling it for $5. Therefore, when the selling price is dictated dictates the selling price, and you want to reach the standard profit margin of the industry, you can use the following formula to calculate the maximum cost price:
Cost = Selling Price*(1-Margin)
For instance, according to Statista, in 2023, the average price for a cappuccino in the major Italian cities was approximately $2. As a result, to make a 30% profit margin, a new café opening in Italy at that time should have a maximum cost price of:
Cost=$2*(1-0.3)=$1.4
The cost price includes ingredients, cups, personnel, rent, electricity, maintenance, cleaning, taxes, and everything else that’s needed to be able to serve a cup of cappuccino.
What Is the Difference between Margin vs. Markup? Includes Example
Margin and markup are both metrics based on selling prices and costs. However, they are not the same thing, and confusing one with the other may result in serious financial issues.
As you have learned so far, the margin represents the portion of revenue that remains as profit. The margin may compare gross sales with net income, selling prices with cost prices, net sales with costs, and so on, but it essentially measures a profit.
The markup represents the percentage difference between the cost price and the selling price. It essentially determines how much you need to add to the cost price to achieve a certain profit. It doesn't show the profitability of your business, like the margin does, but rather how much you want to earn. The formula for the markup is:
Markup (%) = (Selling Price-Cost Price)/(Cost Price)*100
Here is an example. Let’s say that you produce a cup of cappuccino for $1 and need a markup of 50% to remain competitive and invest in your business’s development. The selling price will be:
Selling Price = Cost Price + (Cost Price*Markup)/100=$1+($1*50)/100=$1.5
To sum up the differences between margin and markup, check out this cheat sheet:
Margin | Markup | |
Definition | How much of the revenue, in percentages, stays with you as profit | The difference, in percentages, between the cost price and the selling price |
Formula | Profit Margin (%) = (Revenue-Costs)/Revenue*100 | Markup (%) = (Selling Price-Cost Price)/(Cost Price)*100 |
Usability | Calculate profitability | Calculate competitive selling prices |
Example | An item’s cost price is $1.5 and selling price is $2. The profit margin is | An item’s cost price is $1.5 and selling price is $2. The markup is |
FAQs
What's the difference between gross and net profit margin?
Gross profit margin is the profit made considering the theoretical amount of money made, without subtracting deductions, sales, returns, and so on. Net profit margin takes into consideration all deductions and expenses and shows the amount of money that ends up in your bank account.
How do I calculate a 20% profit margin? (with example)
To calculate a 20% profit margin, use the formula:
Revenue = (Cost*100)/(100-Margin)=Cost*100/80=Cost*1.25
For example, if the cost price of an item is $5, and you want a 20% profit margin, the selling price should be $5 * 1.25 = $6.25
How do I calculate a 10% margin? (with example)
To calculate a 10% profit margin, use the formula:
Revenue = (Cost*100)/(100-Margin)=Cost*100/90=Cost*1.11
For example, if the cost price of an item is $5, and you want a 10% profit margin, the selling price should be $5 * 1.11 = $5.55
Are margin and profit the same?
Margin and profit are not the same thing. A margin is a percentage, a metric that shows a relative change. It’s useful in comparisons, data analysis, and statistics. A profit is an absolute value, the total amount of money made by a product or business. A margin of 10% may result in very different profits when applied to products with different prices.
How do I calculate a 30% margin? (with example)
To calculate a 30% profit margin, use the formula:
Revenue = (Cost*100)/(100-Margin)=Cost*100/70=Cost*1.43
For example, if the cost price of an item is $5, and you want a 30% profit margin, the selling price should be $5 * 1.43 = $7.15
How do I calculate margin in Excel?
Create a column for each of the following: items, cost per item, margin, revenue, and profit. Then, list the items and fill in the cost for each item. Next, fill in the margin. It may be the same for all items or not. In the Revenue column, introduce the formula:
Revenue = (Cost*100)/(100- Margin)
In the Profit column, introduce the formula:
Profit=Revenue-Cost
Sum the total revenue and the total profit.
How do you improve your profit margin?
There are a few things you can do to improve profit margin without selling more, making fewer discounts, or having a rigid return policy, such as:
How do I calculate markup from margin?
Let’s remember the formulas:
Markup (%)=(Selling Price-Cost Price)/(Cost Price)*100
and
Margin (%)=(Selling Price-Cost Price)/(Selling Price)*100
By putting these two together, you can calculate the markup from the margin with the following formula:
Markup (%)=Margin/(1-Margin)*100
For instance, if the profit margin of a product is 25%, the markup will be 33.33%.