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Next Read: Accounting 101: What is Total Revenue?
Profit margin is a percentage that expresses how much of a business’ gross revenues are left over as profit after certain expenses are paid.
There are three different types of profit margin: gross, operating, and net. However, if someone just mentions “profit margin” without specifying which type, they are probably referring to net profit margin, which is the percentage of a business’s gross revenues that are left over as net profit after all of its expenses are paid.
Profit margin is an important concept to understand as a business owner, because it tells you how much profit you can expect to derive from your business’ revenues.
While the past isn’t always indicative of future results, and costs obviously tend to increase over time, your historical profit margins can give you some idea of how much profit your business will earn from the next dollar of revenue it generates.
For example, if your net profit margin has hovered between 14% and 16% for the past few years, that means that your business could reasonably expect to profit between $140,000 and $160,000 from the next $1,000,000 it generates in revenue.
Profit margin is calculated by dividing a business’ profit over its revenue and expressing the result as a percentage.
Here is the general profit margin formula:
(Profit / Revenue) x 100 = Profit Margin
That said, what specifically constitutes “profit” and “revenue” depends on the type of profit margin you’re calculating.
There are three primary types of profit margin, and each have a different calculation:
Gross profit margin is a measure of how much profit a business has after paying only for the direct costs of its sales (Ex: materials and production-specific labor costs).
It is calculated by dividing a company’s gross profit (i.e., its revenue minus its cost of goods sold), by its net sales (i.e., its revenue minus discounts and allowances).
Overhead costs, administrative salaries, depreciation, debt costs, and taxes are generally not considered in gross profit margin. Here is the formula for gross profit margin:
(Gross Profit / Net Sales) x 100 = Gross Profit Margin
Operating profit margin is a measure of how much profit a business has after paying not only for its direct costs of sales, but also operating expenses like overhead costs, administrative salaries, and depreciation. Debt costs and taxes are typically excluded. Here is the formula for operating profit margin:
(Operating Income / Revenue) x 100 = Operating Profit Margin
Net profit margin is a measure of how much profit a business has after paying all of its expenses. Here is the formula for net profit margin:
(Net Profit / Revenue) x 100 = Net Profit Margin
There is no one percentage that is a universally good profit margin. Rather, business owners should think in terms of what is an appropriate margin for their business’ size, stage, and industry.
For example, small businesses generally have higher profit margins than large businesses. For a solopreneur who is doing everything in their business, a “good” profit margin is likely quite high, perhaps exceeding 90%. But for a large corporation with dozens or thousands of employees and significant overhead costs, the profit margin may be much lower, perhaps 10% or less.
Does this mean that the solopreneur’s business’ 90% profit margin is better than the large corporation’s 10% profit margin, simply because it’s higher? No. What matters is that the profit margin is appropriate for your particular business’ characteristics and industry.
Logan Allec is a CPA and owner of tax relief company Choice Tax Relief, which negotiates with the IRS and state revenue departments on behalf of business owners who have fallen behind on their individual, corporate, or payroll tax obligations. With over a decade of experience consulting with business owners about their tax issues, Logan has seen almost everything when it comes to tax negotiations with the IRS and state tax authorities. Prior to starting his own tax resolution practice, Logan was in a managerial capacity at a Big 4 professional services firm, handling tax issues for billion-dollar companies. In addition to running Choice Tax Relief, Logan also owns the personal finance blog Money Done Right, which educates thousands of readers a day about making, saving, and investing money. Logan also runs a YouTube channel on which he publishes weekly videos about what everyday Americans need to know about taxes and tax relief. He has been a licensed CPA since 2010 and holds a master's degree in business taxation from the University of Southern California. Logan lives in the Los Angeles area with his family. When he's not working, he enjoys playing basketball, taking his kids to Disneyland, and discovering new hot sauces to enjoy.
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