Best Of
What Is The Formula For Calculating Profit Margin Ratio?
Article written by Kate Williams
Product Marketing Manager at SurveySparrow
13 min read
25 April 2024
Best Of
Article written by Kate Williams
Product Marketing Manager at SurveySparrow
13 min read
25 April 2024
How do we measure success? As a businessperson, this thought may have crossed your mind on occasion. But before we answer that, let’s see what success is.
Sometimes, success can mean wealth or fame. At other times, it means achieving one’s dreams. But in the end, success can mean many things to people.
Now, if only there were a single formula to tell if you are successful! While this may not be as easy in life, luckily, in business, this is doable.
And this is where the magic of a profit margin ratio comes in. This ratio lets you gauge the success of a company by looking at its profits. And thus, it helps entrepreneurs know if they’re doing well.
But there’s more! Like a doctor’s report, this ratio can give a clean bill of financial health for a company and help impress all the investors.
Sounds simple? Well, not so fast! While the equation is quite simple, there are a few things that can affect it.
Are you curious to know more now? If yes, we’ve got you covered! Below, we’ve compiled a discussion on the profit margin, its types, and its formulas.
So, let’s have a look!
The purpose of setting up a business is to gain a profit from it. But are you wondering how to measure the profits? Well, not to worry, we have the answer right here! This is where theprofit margin ratio comes in handy.
In business, this ratio is used to see how much money a company makes. It looks at the number of sales the company has made and gives a percentage ratio of the profits made. Are you still confused? Perhaps this example can help.
Let’s take a company, A. In the last quarter, they seem to have reported a 35% profit margin. This means that during that quarter, they were able to gather a total income of $0.35 for every unit of sales they made.
Here are a few things to keep in mind about the profit margin ratio.
This margin looks at the degree to which a company makes money by dividing the Income by revenues. And so, it indicates how many cents of profits has been made over each dollar or unit of sales. In doing so, this ratio becomes an indication of success or loss for the company.
For laymen and women, this ratio may not be part and parcel of a daily vocabulary. But to professionals like creditors, investors, and entrepreneurs, this ratio is an important measure. Using this, they can gauge the financial health of a company.
Although the profit margin appears to be a universal figure, it is typically very varied. In each industry, the profit margin ratioappears differently. And so, a small profit margin in one field could be huge in another. Therefore, when a company needs to establish its success, it must be carefully compared with other businesses in the same industry.
Now, we have the key to measuring a company’s success within reach. So, are you wondering how to calculate your profit margin? Well, let’s get right into it!
To calculate the profit margin – the heart and soul of all industries – use these simple steps:
First things first! We all know how profits are decided based on the total revenue. So, the first step is to calculate the earnings of the company.
Here, we can use this simple equation:
Net Income = Gross Income – All Expenses.
Pretty simple, isn’t it? To make it easier, we’ll also quickly break down what these terms mean.
This is every bit of money a company earns in a year. You can look at how much you earn from all the sources put together in a single year. Do make sure you leave no stones unturned in this quest! Once that’s done, voila! You’ll have found out your company’s gross income. Easy, right?
Now, we know this is a no-brainer! But in the interest of full disclosure, here are some usual expenses a company could have: taxes, salaries of their employees, general upkeep and maintenance of services, and so on.
Finally, when the expenses are subtracted from the gross income, it gives you the net income.
In the second and last step, we take the net Income we’ve just calculated and divide it by the revenue or sales of the company. And to turn into a ratio, multiply with the number 100!
And so, in these two steps, you’ll have calculated your company’s profit margin ratio. Pretty cool, right?
Now we’ve got a better understanding of the profit margin ratio. But wait, is that it? Well, in some ways, yes, but in others, not so much! Although the equation [(net income/revenue)x100] remains relatively the same for all profit margins, there are some nuances.
This is because the profit margin is usually a broad category that indicates a company’s financial health. In reality, it has few different types of profit ratios. So, without further delay, let’s take a look!
You won’t have to twist our arms to tell you about this one!
The gross profit margin is based on the cost of sold goods or COGS. Factors like the sales price, number of products sold, and the mix of things you carry can affect the gross profit margin.
So, to improve this profit margin, you’d have to sell products at a higher price than you buy them. Straightforward, right? What’s more! It can even tell you if your company is using its labor force efficiently.
To calculate this one, we’ll leave you with a simple formula:
Gross Profit Margin = (Sales – COGS)/ Sales
The second type of profit margin is the operating profit ratio. What’s this one, you ask? We’ll tell you!
The operating profit is calculated based on the earnings before interests and taxes (EBIT). Here, entrepreneurs can see how well their company has been profiting from its operations.
And to calculate it, all you have to do is use this operating profit margin formula:
Operating Profit Margin = EBIT / Sales
The net profit is another brilliant form of calculating your profit. And, like its counterparts, it’s simple.
Here, the company will need to account for the net Income earned and compare it with the total sales made in a quarter.
Once you get hold of these two figures, feel free to put them into this net profit margin formula:
Net Profit Margin = Net Profit / Sales.
And lo, you shall have found another metric of your success!
With these three types of profit margins, a company can gauge its complete profitability and performance. But what if someone were to ask you, what is your profit margin? Which of these would be the answer then?
Ideally, one would ask more specific questions! But we’ll let it slide for now. Here, it is often understood as a reference to the net profit ratio.
Since the net profit margin is calculated by subtracting all expenses, it is a better indicator of a company’s financial stability. So, in common parlance, profit margin often refers to the net profit.
Here’s where things get more interesting! We now know how to calculate a profit margin, a net profit ratio, and an operating margin. But how do we know the figures are good?
The simple answer? Compare it with your competitors’!
The profit margin varies from one industry to another. However, a good rule of thumb is that a 5% net profit is too low, 10% is average, and 20% is good. So, to see where you stand in your industry, follow these steps.
The first thing to do is to pick one of the profit margin ratio formulas above. Once you’ve got one, do the math to get the figure. Now, hold on tight to this figure while you get set on steps 2 and 3!
Next, look up what profits the other companies in your field are reporting. Do take care to look at the same quarter as yours is from!
And while you’re doing this, see if you can answer these questions in detail:
Armed with this information, you are now set to move on to step 3!
In the final step, place your and the other organization’s numbers side-by-side. Then, while comparing the two, answer these questions:
When you regularly track and analyze the profit margins this way, it’ll get easier to gauge how successful you are. And if the other company’s margins take a plunge, you can use it as an example of what NOT to do for your business.
Do you want to improve your profit margin ratio? Maybe it took a dive, or you want to do better. Either way, here are some ways you can improve it. Let’s take a look!
Markdowns – the profit-killers of the business world – can tank your margins quickly. But how do you avoid them? Here’s how!
You can start by managing your inventory well. Make sure you have a handle on all the merchandise you own. Also, make a note of what sells quickly and what does not.
The more available you make your merchandise, the more likely they are to sell. So, a hundred per cent visible inventory can help avoid the markdown.
Finally, invest in a PIM system. It will give you multiple channels to provide better visibility to all your products.
The staff who engage with clients represent the company. And so, if they are inspired to do more, it can bring up your profit margins. You can improve the employee experience through:
Your employees’ mental and physical health can affect the quality of their work. So, if you can provide them with healthy emotional outlets, it can help improve their morale.
Periodic surveys can gauge how satisfied your employees are with the company. This will then help you improve the inner workings of the workplace. Allow your employees to voice their thoughts in these surveys. If you are unsure how to go ahead with this, you can also rope in an expert like SurveySparrow. With their interactive survey templates, you can understand your employees better.
Be clear in what you expect of them, and allow them the room to achieve these goals in peace. Also, while managing them is necessary, ensure that they are not micromanaged.
Find out what is a popular trend in your market and do your best to cater to it. This will help you jump on the profit bandwagon quickly. If you’re unsure how to do that, no problem! We’ve got some tips for you.
When advertising is done right, it often connects products to the customer’s emotional needs. This can then help drive up its sales.
Carry out surveys to find out how happy your customers are, what they want improved, and how likely they are to recommend your services. Now, with companies like SurveySparrow and Typeform providing customer survey templates, it’s easier to know what your customers want.
Finally, give your customers some discounts that would attract them to your company. However, this will need to be done carefully, or it can lead to a loss for you.
Find the areas of your business that seem to be losing too much money. Then, figure out a way to eliminate them. You can be on the look for the following wastes so that you can avoid them.
And so, with a few steps like these, you can improve your profit margins in no time!
Your profit margin ratio is one of the most critical metrics in business. It must always be on your radar, and for good reasons. For instance, with this ratio, you can improve on the weaker areas, catch red flags in the system, and even project the future growth of your company. It even answers critical questions about the pricing of your products.
Most importantly, it is not a measure that should be allowed to stagnate. As the industry changes, so will its profit margins. And to move with the times, your company will need to up its game.
But here’s some silver lining for you! You do not always have to make drastic changes to improve your profit margins. A simple tweak in the prices, a calculated advertising campaign, or a discount here and there, can increase your profits.
And so, if your profit margins keep rising, you can rest assured that the company is thriving!
Thousands of brands trust SurveySparrow to turn feedback into growth. Try it free today!
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