Methods of Calculating Profit Margin
Profit margins that are needed for a business to survive (or thrive!) are primary metrics that both business owners and sales personnel must know. There are a number of methods of calculating profit margin. Each method provides a different metric that helps businesses make better decisions.
These calculations all begin with the profit and loss statement.
What is a Profit and Loss Statement?
A profit and loss statement (often referred to as a P&L statement) is a report of a business' operating gross income, cost of goods sold and overhead expenses... in that order.
- What is Gross Income? Gross income is all the money that a company receives from sales or other income from the operation of the business. Miscellaneous income such as interest on bank accounts is typically not included in this figure since it is not a product of the business' operations.
- What is Cost of Goods Sold? Also known as "COGS," these are all the costs that are incurred to produce the products and services of the business. Materials needed to make a product would be an example.
- What are Overhead Expenses? Unlike COGS, overhead expenses are all the costs that are incurred to run the business. These are not directly attributable to production of products or services. Items would include utilities, payroll, telephones, etc. Some of these costs are fixed and others are variable. Important: In reporting, note if the total overhead expenses are BEFORE or AFTER taxes. In other words, do they exclude (before tax) or include (after tax) taxes? Both before and after tax metrics should be monitored since taxes can be a huge annual cost that must be considered. Consult an accounting professional to determine an estimated tax rate based on current and applicable tax laws.
Using these three numbers, the profit margins for the business can be calculated. Consulting an accounting professional when preparing financial statements and reports is always recommended.
Calculating Gross Profit
Gross profit, whether in dollars or percentage, is the amount of profit before overhead expenses are deducted. Calculating gross profit margin is done using the following formula:
Gross Income - Cost of Goods Sold = Gross Profit
The result is the gross profit in dollars. This is an important metric, but for sales forecasting, cost of goods sold and gross profit in percentages are more useful.
Cost of Goods Sold ÷ Gross Income = Cost of Goods Sold Percentage
Gross Profit ÷ Gross Income = Gross Profit Margin Percentage
Unfortunately, many business owners and salespeople only look at gross profit when making decisions. What's most important is net profit.
What is Net Profit Margin?
Net profit is the amount of money left over after Cost of Goods Sold (COGS) and overhead expenses are deducted from the gross income.
The formula for net profit in dollars is:
Gross Income - Cost of Goods Sold - Overhead Expenses* = Net Profit
Then to figure the net profit margin as a percentage, one formula is:
Net Profit ÷ Gross Income = Net Profit Margin %
For sales planning, overhead expenses are usually also expressed as a percentage, calculated as follows:
Overhead Expenses* ÷ Gross Income = Overhead %*
Two easier net profit margin percentage formulas for sales and planning use, that come up with the same answer are:
100% - COGS % - Overhead %* = Net Profit Margin %
Gross Profit Margin % - Overhead %* = Net Profit Margin %
This makes is easier to calculate when preparing quotes or evaluating performance. See discussion and examples later on in this article.
* As discussed earlier, whether this amount is before or after taxes should be noted. Having both figures on hand is useful.
Putting It All Together
Now that the necessary numbers have been calculated for profit margin assessment, how are they used for sales forecasting and planning?
In general, COGS expenses vary with the level of sales. Conversely, overhead expenses are often incurred regardless of the level of sales. So every sale must contribute to funding overhead. This is frequently overlooked by many in sales, causing them to quote and discount inappropriately.
Some examples will help illustrate. We'll be using the second net profit margin formula for sales use noted above which is:
Gross Profit Margin % - Overhead Expense % = Net Profit Margin %
- Gross Profit Margin = 60%
- Overhead Expense Percentage = 30%
Plugging this into the formula, the result would be:
- 60% - 30% = 30% Net PROFIT
A result like this would indicate an operation or sale that makes a profit.
- Gross Profit Margin = 30%
- Overhead Expense Percentage = 60%
Plugging this into the formula, the result would be:
- 30% - 60% = (30%) Net LOSS
This business or sale is losing $0.30 on every dollar it makes and will likely go out of business if it cannot either or both: 1) Boost gross profit margin; or, 2) Reduce overhead expenses.
Winning Sales and Losing Business
As is obvious from the preceding examples, it is possible to be making sales, but losing business. Therefore, sharing profitability needs and targets with all sales personnel and relevant staff is essential.
Some businesses are afraid to share their overhead percentages. Yet, by not doing so, they are encouraging their teams to make day-to-day decisions that could cripple the business. As well, sharing an overall overhead percentage is unlikely to divulge any confidential financial information.
In businesses where sales quotes and estimates are the norm, setting both gross and net profit margins for sales personnel to meet on every sale is critical.
What Do "In the Red" and "In the Black" Mean?
In many accounting programs, a net loss on a P&L statement is shown in red ink to call attention to it. Thus, when a business is "in the red," it means it's sustaining losses.
If a business is experiencing profits, a net profit is shown in black ink on the P&L statement. So a business that is "in the black" is doing good... maybe. As noted in the segment "Avoid Robbing Peter to Pay Paul," even a net profit can hide losses within the business.
Trivia Fun Fact: The Friday after Thanksgiving in the U.S. is frequently referred to as "Black Friday" because that is when many retail businesses go from being "in the red" to "in the black."
Avoid Robbing Peter to Pay Paul
Merely looking at the net profit margin in dollars for the entire business can hide the fact that losses from some profit centers or sales are being absorbed by others, in essence creating a "robbing Peter to pay Paul" scenario. Should the profitable center of the business be discontinued, the business could sustain heavy losses or even go out of business.
If all sales, regardless of source, are being lumped into one big total, this lopsided scenario is much more likely. Prior to being able to accurately forecast sales, a business needs to segment and track the income from each of its profit centers. If this has not been done in the past, it can be quite a project to sift through historical sales receipts and determine sales for each center, although the exercise can be very enlightening and helpful.
Similarly, COGS for each profit center needs to be evaluated since lower costs for some products may be hiding very high costs for others.
What is needed to avoid this situation is a separate profit and loss (P&L) statement or report showing the net profit margin for each profit center.
Disclaimer: The author/publisher has used best efforts in preparation of this article. No representations or warranties for its contents, either expressed or implied, are offered or allowed and all parties disclaim any implied warranties of merchantability or fitness for your particular purpose. The advice, strategies and recommendations presented herein may not be suitable for you, your situation or business. Consult with a professional adviser where and when appropriate. The author/publisher shall not be liable for any loss of profit or any other damages, including but not limited to special, incidental, consequential, or other damages. So by reading and using this information, you accept this risk.
© 2013 Heidi Thorne