How to work out your profit margins is essential KPI for your Business. Working out your profit margins should be a key part of regular business audits to ensure a business is profitable. If this is your first time delving into the world of profit margins though the jargon and amount of math-ing can be daunting. First, we need to work out which type of profit margin we’re looking at.
There are 3 main types of profit margins that are commonly used, these are Gross Profit Margin, Operating Profit Margin, and Net Profit Margin.
Gross Profit Margin:
Your "Gross Profit Margin" is the easiest to work out as it’s the business’ revenue minus the Cost of Goods Sold (COGS) divided by revenue.
"Gross Profit Margin % (GPM) = (Revenue – Cost of Goods Sold) ÷ Revenue x 100". Of course, we need to work out our COGS. This is the retail price (what you sell it for) of the product minus the Cost of Purchasing the product from your supplier. So, if a product costs your business £10 to purchase and is sold for £20 we know the Cost Of Goods Sold is £10 or 50%. If we take this in to a larger example, our T-shirt business sells 150 products with a Retail Price of £25 on an average month with each unit costing us £11.25 to buy from our supplier. We, therefore, have a Revenue of £3,750 and a COGS of £1687.50. So our GPM% is (£3750 - £1687.50) ÷ £3750 = 0.55 x 100 = 55% And our GPM(£) is £3750 - £1687.50 = £2062.50. NB. If we change processes and start producing the products we’re selling in-house then we’ll have to take into account the cost of production rather than the cost of purchasing. This may include the cost of staff directly involved in the manufacturing, the cost of raw materials, and the cost of utilities for manufacturing.
Operating Profit Margin:
Operating Profit Margin: The "OPM" or EBIT (Earnings Before Interest and Taxes) takes into account our Gross Profit and other costs involved in the journey of running a business. OPM is generally taken as a better figure of how well a company is making money than Gross Profit is as it accounts for operating expenses. For this one our calculation is: Operating Profit Margin % (OPM) = (Operating income ÷ Total revenue) x 100. Operating Income = Gross Profit – Operating Expenses Phew. That’s a lot of moving parts there but we can break it down relatively easily.
We already know our Gross profit from the previous calculation so we now need to calculate the Operating Income which consists of our Selling and Distribution costs plus any General and Administrative Costs; sometimes abbreviated to SG&A. These include expenses such as rent, advertising, marketing, accounting, commission, research & development costs, travel, staff expenses, salaries, bonuses, etc. So our "Operating Income" is our "Gross Profit" minus our "Operating Expenses". We then divide this figure by our "Sales Income". So, if our business has a Gross Profit of £200,000 and our Operating expenses are £100,000 with £400,000 of Income our calculation is: £200,000 - £100,000 = £100,000 (Operating Income) £100,000 ÷ £400,000 = 0.25 x 100 = 25%.
Net Profit Margin:
Net Profit Margin is considered the ‘Bottom Line’ on our Profit and Loss Accounts. It’s the ‘purest’ profit figure as this is, in essence, what’s leftover after everything has been paid out. Our calculation for this is: Net Profit = Revenue – COGS – Operating Expenses – Interest – Taxes Or Net Profit Margin % = (Net Profit ÷ Revenue) x 100. So let’s use the figures from above on this one too. We know our interest is at £0 and our taxes are £40,000 so our calculation becomes £400,000 - £200,000 - £100,000 - £0 - £40,000 = £60,000 Or (£60,000 ÷ £400,000) = 0.15 x 100 = 15%.
Resources
There are some great resources out there that can help you make sense of your own profit margins and help you set the right pricing levels.
The first one that we love is from OmniCalculator (https://www.omnicalculator.com/collections/sales) and has 15 different calculators for ‘sales’ to get you started.
There is also Gross profit calculator (https://www.bkl.co.uk/insights/tax-calculators/gross-profit-margin-calculator/) from BKL.
Finally, this super easy-to-use VAT Calculator (http://www.vatcalculator.co.uk/) to help you work out product costs/pricing excluding and including VAT.