Profit margin: what is it and formula
If you have a business, or are thinking of starting one, you've probably come across the profit margin formula. This formula is fundamental for the success of a company, yet few know exactly what it is and how to use it.In this article you will find out what profit margin is, what changes between gross and net profit and how to calculate the profit of your business with a simple but effective formula.
What is profit margin?
Expressed as a percentage, profit margin measures the profitability of a business, product or service, net of fixed and variable costs. The higher the percentage the more profitable a business.
From this definition we can already understand how important it is. It's the simplest and most direct way to calculate how much you earn from the sale of each product or service, and it's crucial for understanding if your business is doing well or not.
Now that we’ve recognized the importance of this calculation, let's move on to practice. How do you calculate profit margin?
Profit margin formula
The formula for calculating profit margin is:
Net income divided by net sales, all multiplied by 100.
Net income is total revenue minus expenses, while total net sales is expressed by gross sales minus all discounts, returns, and refunds.
A 10% profit margin is considered average, but there are several factors that influence what is called a “good” profit margin, ranging from the industry your business operates in to its size and years of activity.
To accurately calculate the profitability of your business, you first need to understand the difference between gross and net profit margin.
Gross or net profit margin
To get a complete and accurate picture of the economic situation of your business, you may want to measure both the gross profit margin and the net profit margin.
But what changes between these two values?
Gross profit margin
Gross profit margin is typically used for individual products or services, not for the entire business.
It is obtained by dividing gross profit (the amount of profit the business makes after costs have been deducted) by gross revenue (the total amount of money the business receives from selling products and services), and multiplying the result by 100.
Imagine that your business has produced, in a given period of time, a gross revenue of €1200. To produce these goods, the total cost was €650.
The gross profit margin will be equal to the gross profit (1200-650) divided by the gross revenue (1200).
(1200-650)/1200 = 0,45
Multiplying this result by 100 we obtain the gross profit margin: 45%.
Net profit margin
To calculate the net profit margin, start by dividing the net profit of the business by the net sales, excluding all expenses.
The net profit margin will be given by the net profit (revenue minus fixed and variable costs) divided by the net profit and multiplying the result by 100.
Following the example above, imagine that your business produced a gross revenue of €1200, that its variable costs amounted to a total of €650 and its fixed costs for a total of €150.
In this example, the net profit margin will therefore equal the net profit [1200 - (650+150)] divided by the net profit, multiplied by 100.
So [1200 - (650+150)]/1200] x 100 = (400/1200) x 100 = 33%
Net profit margin is clearly much more accurate than gross profit margin, and the more data you add to your formula the more accurate it will be.
When calculating the costs and revenue needed to measure profit and sales, be sure to track everything from employee payrolls to services, as well as transaction fees and product procurement costs.
You will therefore need to pay attention to the fixed and variable costs of your busines
How do fixed and variable costs affect the profit margin?
Calcolare costi fissi e variabili del tuo business è fondamentale per poter arrivare a un calcolo preciso del margine di profitto netto del tuo business. Se escluderai alcuni costi, il tuo calcolo non sarà attendibile e la tua attività potrebbe risentirne negativamente.
I costi fissi sono le spese che il tuo business deve sostenere a prescindere dal volume di vendita. Al contrario, i costi variabili sono direttamente dipendenti dal volume di beni prodotti.
Vediamo quindi quali sono i costi fissi e variabili principali che dovresti prendere in considerazione per calcolare una percentuale di guadagno il più veritiera possibile.
The fixed costs that you should consider when calculating the profit margin of your business are:
- Rent of the property.
- Fixed utilities required for the premises where you run your business.
- Depreciation of the property and any machinery purchased to produce your products.
- Insurance for personnel, for machinery, or for any cars or company tools.
- Interest expense that you may have to pay in case of any mortgage or loan.
- Government taxes independent of sales volume, such as IMU, property tax, occupation of public land and so on.
- Salaries of employees.
The variable costs to consider when calculating the profit margin of your business are:
- Raw materials needed to produce your products.
- Shipping and transport costs, which increase as the volume of your production increases.
- Maintenance of machinery, which increases along with production and use.
- Variable utilities directly proportional to the consumption necessary to produce your products.
What is a good profit margin for ecommerce?
As mentioned at the beginning of this article, a good profit margin for your company depends on your industry, size, and years of activity.
Typically, retailers have a lower profit margin compared to businesses in other industries. For example, brick-and-mortar retailers usually report an average profit margin between .5 and 4.5%, whereas online retailers tend to have higher net profit margins. In Europe, the average profit margin for ecommerce businesses is approximately 18% (Statista 2023).
So, what constitutes a good profit margin for ecommerce? As you can imagine, determining the ideal profit margin for ecommerce is not straightforward. In fact, a good profit margin for a business that sells specialised technical products might differ significantly from a business that operates in a highly competitive market. Anyway, as a general guideline:
- 5% net profit margin is considered low
- 10% net profit margin is considered average
- 20% net profit margin is considered high
What is a good gross profit margin for ecommerce?
In ecommerce, it is typically considered good to achieve a gross profit margin between 50-70%. However, NYU Stern School of Business reports an average of 41.54% for gross profit margins.
4 ways to increase your ecommerce profit margin
1. Increase Average Order Value
Average order value is the average amount a customer spends per transaction in your store and is calculated in the following way:
total revenue / number of orders = average order value
There are several strategies that you can employ to increase AOV in your ecommerce store:
- Implement upselling or cross selling strategies. Try suggesting products that complement the items that are already in your customers’ cart.
- Suggest similar or popular items on product pages and checkout. Apart from making your customers’ shopping experience easier and more pleasant, you can potentially shift from transactions with low profit margins to those with high profit margins. How? Because a well-placed recommendation can trigger impulse buying or even encourage people to add more products to their cart than they originally intended.
- Offer incentives for minimum order value. Encourage customers to spend a minimum amount and increase your average AOV by offering discounts or even free shipping.
- Create product bundles. Consider offering product bundles that are cheaper to purchase together compared to buying the same items separately.
2. Create a customer loyalty program
Rewarding customers for each purchase based on a point system and giving them access to certain benefits, like Sephora does for example, is a way to encourage people to buy more frequently. In this way, you can transit from low-margin sales to high-margin sales more easily, thus improving your company’s profitability. In fact, once a member earns enough points, they can choose how to use them, obtaining a gift card or a discount on higher-priced products for example.
3. Increase prices
You can start out by performing an ABC analysis to understand which products in your inventory sell more and then you can test their pricing, especially if you have a large catalogue. Remember that increasing prices will work only if you can outperform your competitors. This means providing superior quality and establishing trust with your customers. This can be achieved in several ways:
- Make product catalogues and information easy to find. Including clear product descriptions and allowing customers to perform product research easily will enhance their shopping experience and add more value to your store.
- Communicate your brand story. This will help customers understand the authenticity of your business.
- Provide social proof. Including reviews under your product pages will make your customers feel more confident when buying and motivate them to complete a purchase.
- Include transparent pricing and shipping options. This helps to build trust, reduce cart abandonment, and increase customer satisfaction.
Reduce operating costs
Cutting back on operating costs and expenses is an efficient strategy to increase profit margin. To find out where you can save money, it is important to invest in a good WMS software. This will help you to gain more visibility into your supply chain operations and better manage all expenses by identifying areas of waste in operations.
Tip: Read our full article on What is WMS (Warehouse Management System) and 10 softwares to try and understand how to choose the right technology for your business.
Profit margin: conclusion
By now you should have understood that, although this formula may seem complicated, a consistent and accurate calculation of profit margin (net and gross) will help you to manage your business scrupulously, and plan all the next steps accordingly.
Reducing expenses, cutting back on underperforming products and services, along with expanding your business’ offerings are great ways to improve your profit margin.
Your long-term goal should be to see your profit margin increase year over year, and never fall below a certain threshold.
Profit Margin: Frequently Asked Questions
How do you calculate profit margin?
There are two ways to calculate profit margin which involve determining either gross or net profit. Net profit margin is the most accurate, because it takes into account all expenses involved in sourcing, distributing and selling a given product or service.
What is profit margin?
Profit margin is a percentage that helps you calculate the difference between price and cost in relation to the selling price of your products or services,thus allowing you to measure the profitability of your business. When the margin is greater than zero we speak of profit, if it is less than zero it means that your business is operating at a loss.
How do you calculate gross profit margin?
Gross profit margin is calculated by dividing gross profit (the amount of profit the business makes after costs have been deducted) by gross revenue (the total amount of money the business receives from selling products and services), and multiplying the result by 100.
How do you calculate net profit margin?
The net profit margin is calculated by dividing the business's net income (the profit a company makes after all expenses are paid) by net sales (the money a company makes from selling products and services).
Passionate freelance copywriter, with a niche in ecommerce and logistics. When collaborating with ShippyPro, she loves writing about trends, marketing and communication strategies to help brands gain an edge in an ever-evolving digital landscape.