Independence, flexible schedules and creative autonomy are some examples of the many advantages of being a business owner. However, none of them are relevant if the venture is unprofitable. After all, everyone knows that financial success is the ultimate goal of any entrepreneur, right? Then, how to calculate profit margin?
There are countless challenges when it comes to making a project really profitable and the quality of financial management is a determining factor.
What few people know is how to calculate profit margin, a fundamental and essential management step for growth and commercial support.
Briefly, in order to calculate the profit margin of the company's products and services, managers must follow the following steps:
- understand what profit is;
- establish the profit margin per product or service;
- establish the sales value of the product or service;
- know all business expenses;
- know the charges related to commercial operations;
- apply the specific profit margin formula;
- how to calculate profit margin on sales.
Another important factor to be considered in order to optimize business results and revenues is employee satisfaction. If you want to know more, we recommend reading the article “Falling profits and its relationship with employee dissatisfaction”.
Now, to learn how to calculate your company's profit margin efficiently and practically, keep following this post.
We have prepared a complete guide with all the information you need to apply this calculation with primacy. Good reading!
What is profit?
Before we explore ways of calculating the profit margin, let's understand how profit actually works.
Roughly speaking, profit is the positive return any financial investment, whether made by an individual or a legal entity. Let's see an example?
Imagine that your company resells stylized t-shirts, the cost of each unit in the factory is £ 50 and its sale price in the store is £ 70 reais. In other words, the profit from the operation is £ 20 per shirt sold, right? Wrong!
THE sale process it involves hidden steps that also have a cost and should be considered to calculate that profit in a way more in line with reality. The process includes:
In other words, they must also be considered for the formation of the sale price of the product and, consequently, for the calculation of the profit margin:
- the expense of fuel to get the product from the factory,
- outsourced transportation cost,
- training employees to execute the operation,
- property rental,
- Water,
- light,
- telephone,
- Internet,
- management software, among others.
Thus, if any of these operations exceeds the value of £ 20, their sale generates losses and does not contribute to the success of the business, on the contrary, it slows down its development.
How to calculate profit margin?
Now that you understand what profit is and what the particularities are related to this definition, let's explore how to calculate profit margin.
Profit margin means the percentage that the company aims to earn with the commercial activity of a particular product or service provision. Let's see an example?
Consider your stylized t-shirt store again. The unit cost of the product is £ 50 and the related expenses are £ 30, therefore the effective cost of the piece is £ 80.
Assuming your goal is a 15% profit margin on the sale, the minimum price for each t-shirt must be £ 92, that is, £ 80 + 15%.
In other words, you must calculate the profit margin on sales, consider all costs of the product and, on the final value, add the desired profit margin.
Those £ 20 that seemed to represent a profit previously are, in fact, a loss. Precisely for this reason, know all the values linked to the item or activity is just as important.
The same profit will only be achieved if the consumer market accepts the applied margin and makes the purchase act.
That is, researching the logic used in the market to determine this percentage and knowing the average used by its competitors is an indispensable step in how to calculate profit margin on sales.
What is the difference between gross profit margin and net profit margin?
The profit can be gross or net, and the formulas used to calculate its values are detailed below.
Gross profit
Gross profit it is the value that a company gets after paying all production costs, whether direct or indirect. So to calculate this gross return, just subtract the cost of the goods or service from your total revenue.
Using the same example as T-shirts, suppose your company received £ 15,000 over a month and spent 10,000 to purchase the t-shirts. Thus, gross profit is £ 5,000.
Net profit
Now let's talk about net income. This other type of profit addresses the actual amount of profitability, because discount charges such as taxes and other equivalent expenses.
Consider the gross profit of £ 5,000 acquired in a month of sales and the amount of £ 1,500 in taxes. Net income deducts the amount of this charge to present the value of the final income, that is, £ 3.5 thousand. Therefore, this is the real value that the company obtained from its activities in the period.
How to calculate the gross profit margin?
Having understood the concepts, it is time to learn how to calculate the gross profit margin.
Keep in mind that this percentage varies from item to item, from activity to activity, so it must be calculated several times.
It is worth stressing that the decision as to how much margin will be applied cannot be random. Knowing the average used in the market with competitors is essential.
The calculation of the gross profit margin is made according to the formula:
Gross profit margin = (gross profit / total revenue) x 100
Let's see an example? His stylized t-shirt store earned £ 15,000 in one month and cost £ 10,000. Thus, its revenue is 15,000, its costs are 10,000, and the gross profit is £ 5,000. Following the formula:
MLB = (5,000 / 15,000) x 100
MLB = 33.33%
The gross profit margin applied to the business is 33.33%. This is, therefore, the value that represents the profitability of the business and that can be presented as argument in negotiations and investments.
To help you understand better, see how to calculate the gross profit margin for each T-shirt sold. The commercial price of the product is £ 92, the cost is £ 80 and the profit is £ 12.
MLB = (12/92) x 100
MLB = 13.04%
The gross profit margin actually applied to the product is 13.04%.
How to calculate the net profit margin?
So far we've seen how to calculate the gross profit margin. Now, let's explore the ways on how to calculate the net profit margin.
The difference is basically in the applied discounts, the percentage of the net profit margin also reduces values according to the tax regime and expenses (fixed and variable) of the gross profit.
Net profit margin = (gross profit – general charges / total revenue) x 100
Let's take the example of the T-shirt venture. The business revenue is £ 15 thousand, the costs of executing services are £ 10 thousand, taxes add up to £ 1.5 thousand and fixed and variable expenses count in £ 1,000. Following the formula:
Net profit margin = {[(15.000 – 10.000) – (1.500 – 1.000)] / 15,000} x 100
MLL = {[5.000 – 500] / 15,000} x 100
MLL = {4,500 / 15,000} x 100
Net profit margin = 30%
Therefore, the net profit margin of the business is 30%. The extra taxes represent 3.33% of the profit in the business.
What is the importance of calculating the profit margin?
Understanding how to calculate the profit margin is essential to know the real gains of the business and to identify its status of commercial evolution. This is because knowing and increasing your company's revenue is not enough to ensure the financial health of the company and to structure results optimization.
Many entrepreneurs focus only on sales figures, without paying attention to latent expenses that also impact on the final income from operations.
In this way, any plan applied will be inaccurate and will not be in accordance with the true situation of the business. In other words, the results will only point projections and not certainties.
Among the various variables that must be carefully considered to accurately calculate the profitability of the business are:
- Taxes,
- shipping fees,
- working time,
- trainings,
- billing taxes,
- taxation,
- charges on the sheet,
- administrative costs,
- the rent,
- thirst maintenance,
- Internet, etc.
Therefore, learning how to calculate the profit margin is a fundamental step in management activity and is essential to validate financial operations and know, in fact, the profitability of the business.
Is there an ideal profit margin for your company?
There is no doubt that the higher the profit margin, the better the financial results of any company.
Although there are a number of factors that must be taken into account to define an attractive percentage for the operation, such as:
- market segment,
- type of product or service,
- costs,
- total expenses,
- price wording,
- logic applied in the market, among others.
Even in the face of all this, financial experts present an average for the sectors to be able to rely on.
The ideal average for the sector:
- Industrial: the profit margin must be between 6 and 8%;
- Wholesaler: the profit margin must be between 4 and 6%;
- Tenants and commercial: the profit margin must be between 10% and 15%;
- General services: the profit margin must exceed 20%.
It is important to point out that this is a generic average and that it is not a rule. Business and market conditions must be rigorously analyzed to define this percentage.
Really knowing how to calculate profit margin on sales is indispensable, because any failure can represent a significant loss to the company's profitability, and jeopardize its success.
Thus, following the formulas presented in this post, surely, your company will be able to calculate this percentage safely and structure development plans intelligent and realistic.
Understanding how to calculate the profit margin broadens the managers' view of the business, allows them to know the real results of their plans and the impacts of their decisions on the market.
Therefore, this is a measure that must be applied periodically and strategically.
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Did you like the post? Did you understand the importance of calculating your profit margin with clear criteria? If you still have any questions or want to punctuate your company's experience, tell us here in the comments!
