Profit Margin Formula

What is Profit Margin Formula?

The profit margin formula measures the amount earned (earnings) by the company with respect to each dollar of the sales generated. In short, the profit margin provides an understanding of the percentage of sales, which is left after the company has paid the expenses.

There are three important profit margin metrics, which include gross profit marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold.read more, operating profit marginOperating Profit MarginOperating Profit Margin is the profitability ratio which is used to determine the percentage of the profit which the company generates from its operations before deducting the taxes and the interest and is calculated by dividing the operating profit of the company by its net sales.read more, and net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization's overall profitability after incurring its interest and tax expenses.read more. It is one of the significant ratios of the company as every investor or the potential investor uses this ratio to know the financial position of the company.

Profit Margin Formula

The profit margin ratio can be calculated as below:

Profit-Margin-Formula
Gross Margin Formula = Gross Profit / Net sales x 100
  • The gross profit margin formula is derived by deducting the cost of goods sold from the total revenue.
Operating Margin Ratio = Operating Profit / Net sales x 100
Net Margin Ratio = Net Income / Net sales x 100

Interpretation of Profit Margin

#1 – Gross Profit

It is one of the simplest profitability ratios as it defines that the profit is all the income that remains after deducting only the cost of the goods sold (COGS). The cost of the goods sold includes those expenses only, which are associated with production or the manufacturing of the selling items directly only like raw materials and the labor wages which are required for assembling or making the goods.

This figure does not consider other things like any of the expenses for debt, overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.read more, taxes, etc. This ratio compares the gross profit earned by the company to the total revenue, which reflects the percentage of revenue retained as the profit after the company pays for the cost of production.

#2 – Operating Profit

It is a slightly complex metric when compared with the gross profit ratioThe Gross Profit RatioThe gross profit ratio evaluates the proportion of the direct profit a company generates from its net sales. Here, the gross profit is the returns acquired after considering the cost of goods sold, trade discounts and sales returns for deduction from the total revenue.read more formula as it takes into account all the overhead that is required for running the business like administrative, operating, and sales expenses. This figure, however, excludes non-operational expenses like debt, taxes, etc., but at the same time, it does include depreciation and amortization expenses related to assets.

It is the mid-level profitability ratio, which reflects the percentage of revenue retained as the profit after a company pays for the cost of production and all the overhead that is required for running the business. This ratio also helps indirectly in determining whether the company is able to manage its expenses well or not relative to the net sales and because of which company tries to achieve a higher operating ratio.

#3 – Net Profit

This ratio reflects total [wsm-tooltip header="Residual Income" description="Residual income refers to the net earnings an organization possess after paying off the cost of capital. It is acquired by deducting the equity charges from the company's net profit or income." url="https://www.wallstreetmojo.com/residual-income-formula/"]residual incomeResidual IncomeResidual income refers to the net earnings an organization possess after paying off the cost of capital. It is acquired by deducting the equity charges from the company's net profit or income.read more[/wsm-tooltip], which is left after deducted all non-operating expensesAll Non-operating ExpensesNon operating expenses are those payments which have no relation with the principal business activities. These are the non-recurring items that appear in the company's income statement, along with the regular business expenses.read more from the operating profit, such as debt expenses and the unusual one-time expenses. All the additional income generated from operations, which are not the primary operations like a receipt from the sale of assets, is added.

These ratios are best used for comparing the like-sized companies which are there in the same industry. Also, these ratios are effectively used for measuring the company’s past performance.

Calculation Examples of Profit Margin

Let’s see some simple to advanced examples of profit margin calculation to understand it better.

You can download this Profit Margin Formula Excel Template here – Profit Margin Formula Excel Template

Example #1

For the accounting year ending on December 31, 2019, Company X Ltd has a revenue of $ 2,000,000. The gross profit and the operating profit of the company are $ 1,200,000 and $ 400,000, respectively. The net profit for the year came to $ 200,000. Calculate the profit margins using the profit margin formula.

Solution

Use the following data for calculation of profit margin

  • Net Sales: $2,000,000
  • Gross Profit: $1,200,000
  • Operating Profit: $400,000
  • Net Profit: $200,000

Gross Profit Margin Ratio

Gross Margin can be calculated using the above formula as,

Profit Margin Formula Example 1.1png
  • Gross Margin = $ 1,200,000 / $ 2,000,000 x 100

Gross Profit Margin Ratio will be –

Profit Margin Formula Example 1.2png
  • Gross Profit Margin Ratio = 60%

Operating Profit Margin Ratio Formula

Operating Margin can be calculated using the above formula as,

Profit Margin Formula Example 1.3png
  • Operating Profit Margin ratio = $ 400,000 / $ 2,000,000 x 100

Operating Profit Margin Ratio will be –

Profit Margin Formula Example 1.4png
  • Operating Profit Margin Ratio = 20%

Net Profit Margin Ratio

Net Margin can be calculated using the above formula as,

Profit Margin Formula Example 1.5png
  • Net Profit Margin ratio = $ 200,000 / $ 2,000,000 x 100

Net Profit Margin Ratio will be –

Profit Margin Formula Example 1.6png
  • Net Profit Margin Ratio = 10%

The ratios calculated above shows strong gross, operating, and net profit margins. The healthy profit margins in the above example enabled Company X ltd to maintain decent profits while meeting all the financial obligations.

Example #2

Company Y has the following transaction for the year ending December 31, 2018. Calculate the profit margin.

Use the following data for the calculation of profit margin.

  • Revenue: $500,000
  • Cost of Goods Sold: $300,000
  • Sales, Marketing & Advertising Expenses: $55,000
  • General Administrative Expenses: $45,000
  • Depreciation: $10,000
  • Interest: $15,000
  • Taxes: $10,000

Solution

Gross Profit Margin Ratio

Profit Margin Formula in excel Example 2.1png
  • Gross Profit Margin Ratio = $ 200,000 / $ 500,000 x 100

Gross Profit Margin Ratio will be – 

Example 2.2png
  • Gross Profit Margin ratio = 40%

Operating Profit Margin Ratio

Example 2.3png
  • Operating Profit Margin ratio = $ 90,000 / $ 500,000 x 100

Operating Profit Margin Ratio will be –

Operating Profit Example 2.4png
  • Operating Profit Margin ratio = 18%

Net Profit Margin Ratio

Net Profit Ratio Example 2.5png
  • Net Profit Margin ratio = $ 65,000 / $ 500,000 x 100

Net Profit Margin Ratio will be – 

Example 2.6png
  • Net Profit Margin ratio = 13%

The above example shows that Company Y ltd is having positive gross, operating, and net profit margins and is thus able to meet all its expenses.

Relevance and Uses

Creditors, investors, and other stakeholders use these ratios to measure how effectively a company is able to convert its sales into income. Investors of the company want to be sure that the profits earned by the company are high enough so that dividends can be distributed to them; management uses these ratios to make sure about the working of the company, i.e., profits are high enough to ensure the correct working of company’s operations, creditors need to be sure that the company’s profits are high enough profits for paying back their loans. So all the stakeholders want to know that the company is working efficiently. It the profit margins are extremely low, then this shows that the expenses of the company are too high as compared to sales, and the management should budget and reduce the expenses.

Recommended Articles

This article has been a guide to Profit Margin Formula. Here we discuss the calculation of gross profit margin, operating profit margin, and net profit margin along with examples and a downloadable excel template. You can learn more about financial analysis from the following articles –

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