To be a successful business, it is vital to have a firm understanding of accounting concepts. One of the most critical indicators of a company’s financial health is the profit margin. This figure shows how much profit a company makes on each dollar of sales. To calculate it, you need to know two formulas: gross profit and net profit.
This article will provide a brief guide on calculating profit margin and explaining what each figure represents. We’ll also discuss some accounting terms that are relevant to this calculation.
What is Profit Margin?
Profit margin is a financial metric used to assess a company’s ability to generate income relative to its revenue. Put simply; it measures how much profit a company makes for each dollar of revenue it generates. While profit margin is typically expressed as a percentage, it can also be represented in absolute terms.
For example, if a company has a profit margin of 5%, it generates $0.05 in profit for every $1.00 of revenue. In terms of absolute terms, this would translate to $5 in profit for every $100 in revenue.
What Are the Formulas Necessary to Calculate Profit Margin?
Two formulas are necessary to calculate profit margins: gross and net profit margins.
Gross Profit
Gross profit is calculated by subtracting the cost of goods sold (COGS) from total revenue. COGS refers to the direct costs associated with producing a good or service. In other words, it includes the cost of materials and labor needed to produce a product or deliver a service.
For example, if a company sells furniture, its COGS would include the cost of wood, fabric, and labor needed to assemble the furniture.
Net Profit
Net profit is calculated by subtracting all expenses from total revenue. Expenses include selling, general, and administrative expenses (SG&A), depreciation, and amortization. To calculate profit margin, you would take the net profit and divide it by the total revenue. This will give you a percentage representing the profit made for each sales dollar.
How to Calculate Profit Margin?
Now that we’ve gone over the two formulas necessary to calculate profit margin let’s look at how to actually do it. We’ll use the following example:
XYZ Company has the following financial information for the year:
- Total revenue: $100,000
- Cost of goods sold: $40,000
- Selling, general, and administrative expenses: $10,000
- Depreciation and amortization: $5,000
To calculate gross profit, we would subtract COGS from total revenue. In this case, that would give us a gross profit of $60,000.
To calculate net profit, we would subtract all expenses from total revenue. This would give us a net profit of $45,000.
To calculate the profit margin, we would take the net profit and divide it by the total revenue. In this case, that would give us a profit margin of 45%.
How to Use Profit Margin to Make Better Business Decisions?
Once you understand how to calculate profit margin, you can use this metric to make better business decisions.
For example, if you’re considering expanding your product line, you can use a profit margin to compare the profitability of different products. This will help you determine which products will most likely generate income for your business.
Additionally, if you’re looking to cut costs, you can use a profit margin to identify areas where your company is spending too much money. You can increase your overall profit margin by reducing expenses in these areas.
Profit margin is a vital indicator of a company’s financial health. It tells you how much profit a company makes on each sales dollar. To calculate it, you need to know two formulas: gross profit and net profit.
This article provided a brief guide on calculating profit margin and explained what each figure represents. Additionally, it discussed some accounting terms that are relevant to this calculation. This information allows you to use profit margins to make better business decisions.