Securing funding to start or expand your small business is a big deal. Loan officers, investors, and vendors will want to see financial metrics, like your existing or expected profit margin, before they agree to work with you. That’s because profit margins—gross, operating, and net —go to the heart of whether your business will be profitable.
To better understand the three different profit margins reflected on your business income statement (also called a profit and loss statement), read on.
Gross profit margin
Gross profit is the easiest profitability metric to calculate because it defines profit as all income after subtracting the cost of goods sold (COGS). COGS includes raw materials and wages for labor required to make or assemble goods.
The formula for calculating gross profit margin: ((Net Sales – COGS) ÷Net Sales) x 100
Think of gross profit as measuring the profitability of a single product—if you sell a product for $50 and it costs you $35 to make, your gross profit margin is 30%: (($50–$35) ÷ $50) x 100 = 30%.
Operating profit margin
Operating profit takes into account amortization and depreciation of assets and all overhead, operating, administrative, and sales expenses necessary to run the business. It does not include debts, taxes, or other non-operational expenses.
This profitability margin reflects the percentage of each dollar that remains after payment for all expenses necessary to keep the business running.
The formula for calculating operating profit margin: (Operating Income ÷ Revenue) x 100
Net profit margin
This margin truly measures the profitability of a business because it looks at total sales, total business expenses, and total revenue. It is the true “bottom line.”
Simplified net profit margin formula: (Net Income ÷ Revenue) x 100
More in-depth formula: ((Income – COGS – Operating Expenses – Other expenses – Interest – Taxes) ÷ Revenue) x 100
An ideal margin for your company
Average profit margins vary by industry. Helpfully, NYU conducted a study on profit margins in different industries that gave these net margin numbers:
- Advertising: 19.13%
- Computer services: 6.02%
- Agriculture: 3.18%
- Online retail: 2.97%
- Real estate development: 17.33%
Ultimately, keeping overhead costs low will increase profit margins, which is why any form of consulting business will always carry higher margins.
Reasons to track your profit margins
Beyond securing start-up or expansion funding, having an accurate and up-to-date income statement will:
- Help you grow your business. You’ll be able to see any excess spending and underperforming products or practices. From there, you’ll have a clearer idea of where to expand.
- Allow you to identify and resolve issues. Low profit margins might mean your product is priced too low (or too high if no one is buying them) or that you might have expense management or accounting issues.