## 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 margin, operating profit margin, and net profit margin. 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:

**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**

- Operating profit is derived by deducting all costs of goods sold, depreciation and amortization during the period, and all the other relevant expenses from the total revenue.

**Net Margin Ratio = Net Income / Net sales x 100**

- Net income is derived by deducting total expenses from the total revenues minus, and it is usually the last number that is reported in the income statement.
- Net sales are calculated by deducting any returns from the number of gross sales.

### 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 costs, 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 ratio 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.

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#### #3 – Net Profit

This ratio reflects total residual income, which is left after deducted all non-operating expenses 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.

#### 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

**Gross Profit Margin Ratio**

Gross Margin can be calculated using the above formula as,

- Gross Margin = $ 1,200,000 / $ 2,000,000 x 100

**Gross Profit Margin Ratio will be –**

- Gross Profit Margin Ratio = 60%

**Operating Profit Margin Ratio Formula**

Operating Margin can be calculated using the above formula as,

- Operating Profit Margin ratio = $ 400,000 / $ 2,000,000 x 100

**Operating Profit Margin Ratio will be –**

- Operating Profit Margin Ratio = 20%

**Net Profit Margin Ratio**

Net Margin can be calculated using the above formula as,

- Net Profit Margin ratio = $ 200,000 / $ 2,000,000 x 100

**Net Profit Margin Ratio will be –**

- 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.

**Solution**

**Gross Profit Margin Ratio**

- Gross Profit Margin Ratio = $ 200,000 / $ 500,000 x 100

**Gross Profit Margin Ratio will be – **

- Gross Profit Margin ratio = 40%

**Operating Profit Margin Ratio**

- Operating Profit Margin ratio = $ 90,000 / $ 500,000 x 100

**Operating Profit Margin Ratio will be –**

- Operating Profit Margin ratio = 18%

**Net Profit Margin Ratio**

- Net Profit Margin ratio = $ 65,000 / $ 500,000 x 100

**Net Profit Margin Ratio will be – **

- 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

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