The profit margin or profit margin is an indicator of how profitable a product, service or business is. Here we tell you everything you need to know to learn how to calculate the profit margin. We include key concepts and step-by-step instructions.
You have an idea that you are passionate about, you have the basis of your entrepreneurship. But beyond the desire to do what you like, you need something basic: that what you do leaves you a profit.
For this reason, today we propose you to go fully into one of the keys to entrepreneurial success, which is knowing how to calculate the profit margin.
It may seem as difficult as getting the formula for that well-known soft drink, but the truth is that it is not. In this article, we are going to define what the profit margin is and the essential concepts that you have to know and detail the importance of knowing it. In addition, we will see step by step how to calculate it.
What is profit margin?
Surely you know that profit is a positive return that you receive thanks to an investment. Now, the profit margin or profit margin is an indicator of how profitable a product, service or business is.
The way in which this margin is expressed is through a percentage that, the higher it is, will indicate greater profitability.
What percentage of profit should a product have? The ideal percentage of performance of a product or service when you sell it varies according to the industry in which you develop. Similarly, in general terms, we can establish that the minimum profit margin should be between 10% and 15%.
In the construction sector, for example, a company could consider minimum profit margins that are between 1.5% and 2%. However, in other areas they can reach 40% and 50%. Whatever the industry, learning how to calculate profit margin is essential. You know why? I kept reading!
Why is it important to know the profit margin?
When calculating the profit margin, that percentage that yes or yes we have to add to the cost of the product when defining the sale price, we are doing much more than that.
Calculating it will allow you, for example, to know if the strategy that you implement in your business generates profits. And, with this, know if the providers are the best for you, if they allow you to optimize resources, if there are expenses that are unnecessary or that you must replace.
In addition, it helps you answer essential questions about your business. For example:
- Do sales allow you to pay the entire team?
- Does your marketing strategy generate more benefits than expenses?
- Are you considering everything you have to pay for your product to be in the hands of your consumers?
When you know how to calculate profit margin and do it correctly, you can make more strategic decisions for your business. It can also help you to know how the operations of your business are going and if it is solid.
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What are the elements to consider to calculate the profit margin?
Part of knowing how to calculate profit margin is understanding its elements. These are mainly three:
- this is the amount of money you invest to produce what you sell. Think in this category of elements such as taxes, water, electricity, internet, labor charges, telephone, etc.
- Sale price: of your products you have to try to balance costs and, at the same time, keep an eye on the prices of the competition. At this point, it is key that you rely on all the data you can on how to .
- Gain: Or we can also say utility. And what is utility? It is the percentage you receive for the sale of your products or services.
As you can imagine, after having seen these elements, there are several considerations to take into account when calculating your profit margin. This is because there is both a gross profit or gross profit and a net profit or net profit.
Types of profit margin
Before we go into the step by step of how to calculate the profit margin, it is important that you know that there are two types.
One of them focuses more on how to calculate the profit of a product and the other is more macro and measures entrepreneurship. Let’s see in detail what each one is and how they are calculated.
Gross profit
This type of profit margin allows you to know what final value you got after selling a product or service. Knowing how to calculate this margin is knowing how the profit of a product is calculated.
To obtain it, you have to subtract from that value the costs of its production. Typically, this calculation is used for a product or line, not an entire business.
Let’s see this calculation with an example. If you sold your product for $10,000 and the total cost is $8,000, the difference is $2,000. To get the percentage, you have to divide the difference between the sales and multiply by 100, in our example, the percentage will be 20%. That number comes from $2,000 / $10.00 and, whatever it gives you, multiply it by 100.
The general formula you can follow is:
Percent gross margin = (gross profit / total revenue) x 100.
Keep in mind that in the calculation of the gross profit margin, costs such as rent, office expenses and others are not considered. That is, indirect costs are not considered, only direct.
Net income
In this case, the profit is not calculated on a product but it will tell you the profitability of your entire enterprise. Like gross profit, it is a percentage figure. The higher the percentage, the higher the profitability of your business.
Pay close attention to this margin because, if it is too low, you may have to review your expenses. You may also need to check if you are managing well or if there are productivity problems.
Consider that, unlike the gross profit, here you will need the income and costs of your entire venture, not just one product.
You will have to divide the net income of your business by the total sales. Then you have to multiply that result by 100 to arrive at the percentage. It is important that you do not compare what you get with a business from another industry since, as we saw, these percentages vary according to the category.
To learn how to calculate the net profit margin, we will also use an example. If your gross sales are $100,000 and your expenses are $50,000, your net income will be $50,000.
So, you have to divide $50,000 by $100,000, as a first step to calculate the net profit margin. That account is going to give 0.5 and to that number, multiply it by 100 to arrive at a percentage that in this case will be 50%.
Here you are going to include expenses such as taxes, rent, electricity, internet, water, etc., not as in gross profits.
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How to calculate the profit margin?
To calculate the profit margin you have to, first, know all the costs linked to the product or service offered by your business. Then, you will have to add the costs that you identify as associated, directly or indirectly, with the production and delivery of your product or service.
The next step is to calculate the gross profit or gross profit per product. We have already seen how to do it in the previous section. The difference is that now it is also important that you calculate the gross profit for a month. For this, it is necessary to consider how much you earn for what you sell during a month and what your costs were during the month.
You have to subtract those numbers. That is, subtract the expenses from the income for your products. That would be the gross profit for the month. Later, to obtain the percentage you will have to divide that number you obtained by the income from your monthly sales and multiply the result by one hundred. This is how you arrive at the monthly gross profit percentage.
With this last data, you will be able to obtain the net profit later. But first, it is convenient that you make a list of fixed and variable expenses:
- The fixed ones are those that you have to pay monthly for your business to work (for example, rent, electricity, gas, water, etc.).
- Variables are those that change from month to month (for example, a loan, a machinery repair, etc.).
Now yes, you can calculate the net income for the month. Which you are going to arrive at like this: gross profit – relationship between expenses. To get the percentage, you have to follow this calculation:
x100.
In calculating your profit margin, it is key that you consider:
- That the payments to your collaborators and the seasonality of the inputs can alter the values ​​that you foresee for the cost of production. Therefore, it is best to average expenses over a period when calculating your profit margin.
- The sales cycle of your product. To arrive at a final sale price, you have to consider each part that makes up your product, from advertising actions to after-sales services.
- Exploring what return you are going to have from each investment you make is as important as knowing your profit margin.
Learn more about the concept of return on investment:
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How to get the profit percentage in Excel or Google Sheets?
We are going to see a step by step on how to get the profit percentage. In our case, we are going to use Google Sheets, but it works with Excel as well.
1. First things first: create a new spreadsheet
Inside it, add the columns: Revenue, Cost of production, Profit and Profit margin.
2. Everything ready to start completing
The first thing you have to do to continue is to place in income the unit price at which you sell your product, for example, $100. Then, add your production cost in the corresponding cell, suppose in our case it is $50.
Now, you can calculate the gross profit, which will appear in the “Profit” column. How? Use this formula: =B2-C2, and voila!
3. Now yes, your profit margin is a formula away
The formula that we saw above, in Excel and in Google Sheets translates like this: D2/B2*100. The result, in our example, is 50.
4. It’s time to know your net profit margin
The first step to this is knowing your profit margin for the entire month. For that, add a column with the number of products you sold per day. We’re going to call it Products Sold and we’re going to put it next to Revenue. Also, in the gray column we are going to put the month, suppose it was October.
The formula, once you have added that column, in this case is going to be: =B2*100 (100 corresponds to the income that each product means, as we used before). Then, below everything you complete for the month, add a cell for the totals. In our example, we don’t complete every day of the month, but you…
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