Comparing Different Methods for Profit Margin Calculation: Pros and Cons

Profit is an essential part of any business, whether you’re making, editing, or distributing movies, or running any other venture whatsoever. In fact, it’s the only real reason to be in business—to earn money.

This is why it’s so important to focus on revenue, on how much money you’re bringing in as a business. Of course, there is a flip side to this – how much money you’re spending as a business. This is where profit comes in. It’s how much you earn, less how much you spend. This gives you your profit margin.

Why Is It So Important To Know Your Profit Margins?

Knowing what your profit margins are will give you a better understanding of the financial health of your business. You can also only properly understand the growth potential of your venture when you understand how much you make in profit on each sale.

Your profit margin is one of the key financial indicators that potential investors will look at. This is essential if you’re looking to bring in an investor as a startup, or in order to expand your operation.

3 Profit Margin Calculations for Your Business

Many people simply assume that you take your revenue from sales and subtract the business expenses, and then you have your profit margin. This is a very simplistic view of the calculation. It’s also important to note that profit margins are usually shown as a percentage. You need to divide that number by income and multiply by 100 to get that percentage.

There are actually three different types of profit margins that you should be looking at:

Gross Profit

Your first calculation is the simplest one and it looks at only the costs and income involved in making a sale. You take the income from the sale and subtract the cost of the goods sold (COGS). These expenses are the ones that are directly involved in the item you sell. This includes the raw materials and manufacturing costs if you make the items or brand them. If not, it includes the purchase and shipping prices involved in the resale of the item.

The benefit of this calculation is that you see immediately how much each sale costs. You need to spend a specific amount of money to make a specific amount of money. You can also find ways to bring down those costs involved, such as using cheaper suppliers, reducing the steps involved in the manufacturing process, and so on.

The problem with this calculation is that you aren’t getting an overall view of your company’s finances. This calculation doesn’t take into account overheads like office or factory rental, the once-off cost to buy the machine that makes the product, and wages for staff not directly involved in manufacture or sales.

Operating Profit

Now you start to look more at your business expenses and how those correlate with the income you’re bringing in. This calculation takes into account all of your overheads—from rent or rates on your premises to administrative expenses—everything that’s required to actually run your business.

Your income in this calculation is once again all money received from sales.

Your operating profit margin is usually the one that investors are the most interested in. It gives a very clear indication of how well your business is run and what potential it has for growth. It can show you just how efficiently your business operates and if there are any expenses that could be cut or reduced.

It’s a great idea to have both your gross profit and your operating profit as a comparison. If you break down each of your products and see the gross profit on them, you can see which ones are giving you the most bang for your buck. You can then compare those figures to your operating profit margin to see if there is a disconnect. If you’re spending too much on operating costs, you can see it clearly in these two profit margin figures.

Net Profit

Finally, this is the most complex profit margin calculation, and it shows you the absolute bottom line for your business. For this one, you take all income from sales and any additional streams that you might offer or have in your business. You also then take all expenses, such as the cost of goods, operational expenses and whatever other costs you incur. These additional expenses could be taxes, once-off expenses, interest, or payments on debts.

This covers all financial elements of your business to give you the final figure of how profitable you are. It’s important to know this amount because it gives you an overview of how your business is faring financially. This high-level information can help you to make decisions about how to move forward financially and whether you can afford to invest in new equipment, upgrades to your premises, or hiring new staff.

It’s just important to note that you should always look at your net profit margin in conjunction with the other two calculations. The more granular level that the other two provide gives you insights that this overview can’t give. On the other side of the coin, this overview tells you what direction your business is moving in.

What Qualifies As A Good Profit Margin?

It’s not a one-size-fits-all answer because healthy margins can vary wildly between industries.

What qualifies as healthy can also depend on the size of your business. The larger the business, the more likely you are to see a higher profit margin. 10% is usually considered an average profit margin, while anything under 5% is considered to be a problem or warning sign for a business. If you’re at 20% or higher, then you’re doing well for yourself.

Ensure You Have All The Information At Your Fingertips

Knowing how to calculate profit margin is crucial for running a financially viable business. All three of these calculations provide you with invaluable insights into what makes you money and how you’re spending it—or how you should be spending it. With this information, you can make data-driven decisions that not only keep your venture afloat, but help it to thrive.