What is a profit margin?

It's a good rule of thumb to make more money than you spend. It's true in personal finance and it's true for any business. A profit margin essentially tracks this part of any business operation. A profit margin is the percentage you make from every dollar of your sales. The higher that percentage, the higher your profit margins.

Depending on your needs, you may calculate gross or net profit margins. Gross profit margins focus on your profit after the cost of creating your goods, while net profit margins factor in the additional expenses of your business.

Why is it important to calculate a profit margin?

Profit margin calculations help you make better, data-informed decisions about what your business needs. The ability to accurately measure and predict your profit helps you with budgeting, vendor selection, and if you can-or should-open a brick-and-mortar location in addition to your online store.

Whether your business grows can be decided by these numbers. If profit isn't marginally growing, or is slumping or remaining static, then chances are you'll have to wait until you find some cost efficiencies.

Understanding the financial health of your business is paramount for its success. What you consider a success depends on your needs, the products you're selling, and for how long. For new entrepreneurs and business owners, success in the first year may look like breaking even, and second- or third-year success may mean gradually increasing profit margins.

When do you need to calculate a profit margin?

Keep track of how your business is doing on a regular basis. What that cadence looks like is up to you. For net profit margin calculations, that can be done on a quarterly basis. To better understand the specific sales of some products, consider calculating the gross margin profit monthly.

Read our guide to small business finances

Types of profit margins

There isn't just one profit margin businesses can look at to understand their profitability. Generally, there are three types of profit margins business owners calculate for better insight into how well their business is doing.

1. Gross profit margin

The gross profit margin is calculated by subtracting the cost of goods sold (COGS) from the overall profit. COGS includes any raw materials needed for products and additional costs for the product, like labor (manufacturing or packaging and shipping).

Your gross margin profit for specific products or services helps you to understand how well they're selling relative to the cost that goes into making them. If your gross profit is low or negative-when the price doesn't cover the total cost of creating the product-then you may want to consider raising the price of a product or decide if it's the right product to sell.

To determine what your gross profit margin is, use this calculation: ((Net sales - COGS) / Net sales) x 100 = Gross profit margin

Say you're a small business selling print on demand (POD) t-shirts and your net sales are $10,000 but your COGS amount is $6,000. The difference is $4,000. From there, take that difference ($4,000) and divide it by the net sales ($10,000). This yields 0.40, and when multiplied by 100, is 40%. Your gross profit margin is 40%.

2. Operating profit margin

Calculating your operational profit margin is a lot like determining the gross profit margin, except that this amount takes into consideration all of the costs involved in running a business, not just COGS. This includes administrative costs-anything from the ink cartridges you need for a printer to software for processing sales. If you have a physical space, like a brick-and-mortar store, you'd factor the rent of it in here.

Operating profit margin shows the business' profitability from an operating standpoint vs. purely on product sales, like with gross profit margin.

To calculate your operating profit margin, first you need to know your operating income. Operating income is your net sales before interest and taxes are taken out, also known as EBIT. In other words, your gross sales, minus COGS and any other operating costs.

To determine what your operating profit margin is, use this calculation: (Operating income / Net sales) x 100 = Operating profit

Let's use the same example of a print on demand t-shirt operation. Net sales are still $10,000 and COGS are $6,000. Your operational costs are $2,000, which means your total operational costs are $8,000. That leaves you with $2,000 in operating income. Divide that number by $10,000 (your net sales) and multiply by 100 to get a 20% operating profit.

3. Net profit margin

The last profit margin type is net profit margin, which calculates your revenue after incorporating every business expense, such as administrative costs, COGS, taxes, interest, and depreciation. Depreciation refers to the value of a business' equipment or assets, like machinery or real estate, but often isn't a factor for smaller businesses.

Your net profit margin is more colloquially called your bottom line. It's how well the business is doing. It's the closest possible number to give you (and any other interested party) an overall financial picture. For new businesses, this is a great metric to help you identify growth opportunities or where to reduce costs for future growth.

To determine what your net profit margin is, use this calculation:
((Net sales - COGS - operating expenses - taxes - interest) / Net sales) x 100 = Net profit margin

Let's use the same example in this final profit margin type. For the POD t-shirt business, let's say net sales, or revenue, is $50,000. The COGS amount is $18,000, operational costs are $6,000, tax is $5,000 and interest is $5,000. Net profit is $16,000. Divide that amount by the revenue and multiply by 100. The net profit margin for this example is 32%.

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