Investopedia: What is the formula for calculating profit margins?

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What is the formula for calculating profit margins?

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By Investopedia
Updated Jun 21, 2019
Table of Contents

    Gross Profit Margin
    Operating Profit Margin
    Net Profit Margin
    Example of Profit Margin

Profit margins are perhaps the simplest and most widely used financial ratios in corporate finance. A company's profit is calculated at three levels on its income statement, starting with the most basic – gross profit – and building up to the most comprehensive – net profit. Between these two lies operating profit. All three have corresponding profit margins calculated by dividing the profit figure by revenue and multiplying by 100.
Key Takeaways

    Calculating profit margins help us to understand the relative profitability of a firm or business activity.
    Margins are typically computed from gross profit, operating profit, or net profit.
    The greater the profit margin, the better, but a high gross margin and a small net margin may indicate something that needs further investigation.

Gross Profit Margin

Gross profit is the simplest profitability metric because it defines profit as all income that remains after accounting for the cost of goods sold (COGS). COGS includes only those expenses directly associated with the production or manufacture of items for sale, including raw materials and wages for labor required to make or assemble goods. Excluded from this figure are, among other things, any expenses for debt, taxes, operating or overhead costs, and one-time expenditures such as equipment purchases. The gross profit margin compares gross profit to total revenue, reflecting the percentage of each revenue dollar that is retained as profit after paying for the cost of production.

The formula for gross profit margin is:
Gross Profit Margin formula
Gross Profit Margin formula. Investopedia
Operating Profit Margin

A slightly more complex metric, operating profit also takes into account all overhead, operating, administrative and sales expenses necessary to run the business on a day-to-day basis. While this figure still excludes debts, taxes and other non-operational expenses, it does include the amortization and depreciation of assets. By dividing operating profit by revenue, this mid-level profitability margin reflects the percentage of each dollar that remains after payment for all expenses necessary to keep the business running.

The formula for operating profit margin is:
How to Calculate Profit Margins
Net Profit Margin

The infamous bottom line, net income, reflects the total amount of revenue left over after all expenses and additional income streams are accounted for. This includes COGS and operational expenses as referenced above, but it also includes payments on debts, taxes, one-time expenses or payments, and any income from investments or secondary operations. The net profit margin reflects a company's overall ability to turn income into profit.

The formulae for net profit margin are either;:
Net Profit Margin Formulas
Net Profit Margin Formulas.  Investopedia
Example of Profit Margin

For the fiscal year ended October 2016, Starbucks Corp (SBUX) recorded revenue of $21.32 billion. Gross profit and operating profit clock in at healthy figures of $12.8 billion and $4.17 billion respectively. The net profit for the year is $2.82 billion. The profit margins for Starbucks would therefore be calculated as:

Gross profit margin = ($12.8 billion ÷ $21.32 billion) x 100 = 60.07%.

Operating profit margin = ($4.17 billion ÷ $21.32 billion) x 100 = 19.57%.

Net profit margin = ($2.82 billion ÷ $21.32 billion) x 100 = 13.22%.

This example illustrates the importance of having strong gross and operating profit margins. Weakness at these levels indicates that money is being lost on basic operations, leaving little revenue for other expenses. The healthy gross and operating profit margins in the above example enabled Starbucks to maintain decent profits while still meeting all of its other financial obligations.

For business owners, profitability metrics are important because they highlight points of weakness in the operational model and enable year-to-year performance comparison. For investors, a company's profitability has important implications for its future growth and investment potential. In addition, this type of financial analysis allows both management and investors to see how the company stacks up against the competition.
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Related Terms
How to Calculate Net Profit Margin Using Apple's Revenue and Profit
The net profit margin is the ratio of net profits to revenues for a company or business segment. Expressed as a percentage, the net profit margin shows how much of each dollar collected by a company as revenue translates into profit.
more
Why Gross Profit Margin Matters
The gross profit margin is a metric used to assess a firm's financial health and is equal to revenue less cost of goods sold as a percent of total revenue.
more
Gross Margin Defined
The gross margin represents the amount of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by the company.
more
Operating Profit
Operating profit is the profit from a firm's core business operations, excluding deductions of interest and tax.
more
What Gross Profit Tells Us
Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of providing its services.
more
Common Size Income Statement
A common size income statement is an income statement in which each account is expressed as a percentage of the value of sales, to make analysis easier.
more

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