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What Is The Formula For Calculating Profit Margin Ratio?

Kate William

8 min read

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!

Understanding The Profit Margin Ratio

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. 

3 Key Points About Profit Margin Ratio

Here are a few things to keep in mind about the profit margin ratio.

#1 What It Tells About A Company

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. 

#2 Who Uses The Profit Margin Ratio

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. 

#3 The Profit Margin Is Varied

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. 

How To Calculate Profit Margin Ratio?

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: 

1. Calculate the Net Income

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.

#1 Gross Income

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?

#2 The Expenses

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. 

#3 Net Income

Finally, when the expenses are subtracted from the gross income, it gives you the net income. 

2. Calculating The Profit Margin Ratio

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?

Types Of Profit Margin Ratios

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!

1. Gross Profit Margin 

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

2. Operating Profit Margin 

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

3. Net Profit Margin 

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!

Resolving a Common Dilemma

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. 

What Is A Good Profit Margin Ratio?

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. 

1. Calculate the Ratio

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! 

2. Research Your Competitors’ Margins

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: 

  • What is my competitors’ gross profit margin?
  • What is their operating margin?
  • How much is their net profit?
  • Did their margins increase or decrease over time? 

Armed with this information, you are now set to move on to step 3! 

3. Comparing The Results

In the final step, place your and the other organization’s numbers side-by-side. Then, while comparing the two, answer these questions:

  • How does my profit margin ratio differ from theirs?
  • Have theirs improved over time?
  • What can I do to improve my profit margin? 

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.

How To Improve Your Profit Margins

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! 

1. Do Your Best To Avoid Markdowns

Markdowns – the profit-killers of the business world – can tank your margins quickly. But how do you avoid them? Here’s how! 

Tip#1: Manage the Inventory 

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. 

Tip#2: Make The Inventory More Visible

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. 

Tip#3: Product Information Management System (PIM)

Finally, invest in a PIM system. It will give you multiple channels to provide better visibility to all your products.

2. Inspire Your Staff To Do More

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: 

Tip#1: Employee Wellness Checks

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. 

Tip#2: Satisfaction Surveys

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. 

Tip#3: Set Simple and Straightforward Goals

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. 

3. Cater to Customer Needs

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.

Tip#1: Address Their Emotions

When advertising is done right, it often connects products to the customer’s emotional needs. This can then help drive up its sales. 

Tip#2: Online Surveys

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 SurveyMonkey providing customer survey templates, it’s easier to know what your customers want

Tip#3: Seasonal Discounts

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. 

4. Eliminate Waste

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. 

  • Defects – This is often caused by mismanagement of the inventory, poor quality control, and so on. 
  • Overproduction – This can lead to your products not being sold and losing money.  
  • Waiting – If there is too much downtime between workloads, there needs to be restructuring in the system. 
  • Underutilized Talents – The potential of your labor force is not utilized well. This means you won’t bring as many profits as you had hoped. 
  • Transportation – Wasted transportation, fuel costs, and so on must be looked at. 
  • Excess Goods – There is an excess in your inventory, and you may need to return or repair the ones that do not meet the customer’s needs. 
  • Inefficient Store Layout – If the store layout is too cluttered, it can cause you to lose money over the reduced productivity rates. 

And so, with a few steps like these, you can improve your profit margins in no time! 

Wrapping Up…

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! 

 

Kate William

Content Marketer at SurveySparrow

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