Quick Summary
This article is about calculating and analyzing profit margin ratios, specifically gross, operating, and net profit margins. Each ratio is a profitability metric used to measure business financial efficiency. A business can assess its financial health by comparing these ratios to industry averages and to its past performance. Industry profitability data can be obtained from Statistics Canada. Profitability metrics should be used alongside historical data to track trends and make data-driven decisions.
15 Must-Track Metrics & KPIs for Nonprofit Success
How to Calculate Your Gross, Operating & Net Profit Margin Ratios
Does your sales revenue exceed your expenses? If so, there’s a good chance your cash flow is positive, and your business makes a profit.
Profitability is a key objective for every business owner—a core reason for starting and running a business. But looking at your profits solely as a dollar amount means you only see part of your business’s financial picture. It can’t tell you why your business is profitable or how sustainable your profitability is.
By converting different types of profit (like the company gross profit, operating profit, and net income on your income statement) into margin ratios, you can more effectively measure your financial efficiency and compare your performance with competing businesses or your business's past performance.
We show you how to calculate gross, operating, and net profit margin ratios. We also explain each profit ratio, what each means for you, and how understanding these ratios can improve your business’s financial health. Let's start with the foundations: Gross profit margin measures your company's efficiency; operating profit margin takes all operating costs into account, and net profit margin is the most comprehensive measure of profitability.
Gross Profit Margin Ratios
Your gross profit equals your total revenue, less the direct costs (including materials, direct labour, packaging, and shipping) of producing your goods.
Gross Profit = Net Sales – Cost of Goods Sold (COGS)
Your gross profit margin is a metric that indicates profitability. After subtracting the cost of goods sold (COGS), it indicates the revenue left and is expressed as a percentage of total revenue.
Gross Profit Margin = (Gross Profit / Sales) x 100
Here’s an example of the gross profit margin ratio in action.
The Simple Deli sells sandwiches and coffee. For the fiscal year ending December 31, 2020, they reported total sales of $564,920, and COGS of $125,00 on their income statement. Based on those numbers, their gross profit was $439,920, and their gross margin was 77.87%. That means, for every dollar The Simple Deli generated in sales, they generated 77 cents in gross profit before other business expenses were paid.
By looking at your direct costs only, gross profit margin shows how financially efficient your business is at turning raw materials and production labour into the goods or services you sell. Generally speaking, the higher your gross margin, the higher your profits.
You can also use a product or service’s gross margin to determine its profit potential. Here’s how that works.
The Simple Deli’s total sales in 2020 consisted of $505,400 in sandwich sales, and $59,520 in coffee sales. With a food cost of $106,400, and a beverage cost of $18,600, their gross margin on sandwiches was 78.95%, while their gross margin on coffee was 68.75%. In view of their coffee’s lower margin, the company could look to reduce their cost through bulk purchases or to increase their markup per cup.
Operating Profit Margin Ratios
Your operating profit equals your total revenue, less your COGS, operating expenses (including selling and administrative expenses), and depreciation & amortization.
Operating Profit = Gross Profit – Operating Expenses – Depreciation & Amortization
Operating Profit Margin = (Operating Profit / Sales) x 100
Here’s an example of the operating profit margin ratio in action.
For the fiscal year ending December 31, 2020, The Simple Deli reported total sales of $564,920 and a gross profit of $439,920. Their operating expenses for the year were $318,960. Based on those numbers, the company’s operating profit was $120,960, and their operating margin was 21.41%.
By taking all your costs of doing business into account, operating profit margin shows how financially efficient your business is at controlling operational costs and expenses.
While an operating margin that trends higher over time is ideal, this ratio is mainly used to compare a company’s operations with those of its competitors.
Net Profit Margin Ratios
As the last line on your income statement, your net profit is literally your company’s bottom line – and one of the most important indicators of financial health.
Net Profit = Operating Profit – Interest – Taxes
Net Profit Margin = (Net Profit / Sales) x 100
Here’s an example of the net profit margin ratio in action.
For the fiscal year ending December 31, 2020, The Simple Deli reported total sales of $564,920 and an operating profit of $120,960. They also had income tax owing of $45,099. Based on those numbers, their net profit was $75,861, and their net margin was 13.43%.
Because it takes all your costs into account, net profit margin is the most granular and conclusive profitability metric.
What is a Good Profit Margin?
Understanding if your profit margin is good is highly dependent on the industry you're in and the stage of your organization's life cycle. Essentially, profit margins are highly variable from one industry to another because of the different economic factors that are involved. When analyzing your profit margin, it's very important to ensure you're making an apples-to-apples comparison, considering both industry and company maturity. For example, the profit margin in food service-based industries is typically very low, often as low as 4%. Conversely, consultants or other professional service-based companies typically see much higher profit margins because their businesses have less overhead. Both of these examples would also depend on whether your company is just starting out or well-established, stable and mature. It's usually understood that businesses take time to ramp up and become consistently profitable by managing their costs and expenses. All in all, it's difficult to definitively answer the "what's a good profit margin?" question because of all of these factors. A good place to start is by making connections in your industry and seeking benchmarking data around profit margins from other similar businesses where you can.
Final Thoughts
While the ideal net profit margin varies with industry and company size, 10% is a reasonably good average for most businesses. Meanwhile, any profit ratio above the average for an industry can be considered a competitive advantage.
If you want to improve your net company profit margin, increase sales, reduce expenses, or do both! Higher sales often mean higher total expenses. To cut business costs, it may be a good idea to outsourcing certain tasks - like bookkeeping or HR, for example - to cut costs.
Using profitability metrics in conjunction with your historical data will help you to:
- Conduct year-over-year comparisons: This allows you to take a big picture view of your organization's financial health and compare one full calendar year's performance to another.
- Monitor your overall financial performance: While weeks and months have their ups and downs, the goal would be to see your profitability heading in an upwards direction from one year to the next.
- Make better, data-driven decisions: Rather than assuming or hoping that things are moving in the right direction, use the data to tell the story. If you are continually struggling to achieve a healthy profit margin, it might be time to make some tough decisions.
Remember, just because your business is profitable dollar-wise doesn’t necessarily mean it’s financially healthy. There are other factors that go into determining the financial health of a business, including how much debt the organization is carrying, the cost of stored inventory and the status of receivables (ie: money the business is owed). Frankly, the only way to calculate and analyze your gross, operating & net margin ratios is with an accurate set of books. If you need help bringing your financial data up to date, Enkel can help. Reach out to us.
