Want to find out how much income you’re making for every pound spent? You need to calculate your profit margin.
As a business owner, the profit margin is an important metric to know. But while it should be simple to calculate in theory, it’s slightly complicated by having to talk about gross profit and net profit.
Here’s how you can calculate your small business’ profit margin step by step. We’ll also have a look at what a healthy profit margin should look like if your small business is based in the UK.
Gross profit is your sales revenue minus the cost of goods sold. By contrast, your net profit is your sales revenue minus the cost of goods sold and other business operating costs.
Let’s say you sell coffee:
We’ll delve into allowable expenses in more detail later. However, broadly speaking, they’d include expenses such as your employees’ salaries, the cost of renting your premises, marketing, business insurance and more.
Some people confuse gross profit and net profit with what is turnover. But turnover is something different. Turnover is the amount of money your business makes over a particular period of time.
You can also refer to turnover as sales, revenue or income. Accountants generally take turnover to mean net sales — the amount of sales excluding VAT.
You can calculate your business’ gross profit using a simple formula:
Sales - Cost of Goods Sold = Gross Profit
The cost of goods sold is the amount of money you spend to produce your product. This is also known as the direct cost of sales. It includes
In simple terms, gross profit shows you how much value you’re getting from selling a product or service.
That said, it’s only a rough snapshot. Gross profit doesn’t take into account operating expenses (which you deduct to find your operating profit), tax, payroll and interest. For this reason, your gross profit could indicate you’re a multi-millionaire, but your net profit might tell a different story.
Well, knowing your gross profit is valuable. You can use gross profit to figure out how much income you generate from your products or services. And you can then use this to work out if your profit margin is acceptable.
If you’re not happy with your gross profit, you might have to cut your production costs or increase your prices. It’s a useful step towards making savings.
If you’re happy with your gross profit but still have to make savings, this will tell you that the issues lie with overheads or taxation. You can identify these with your operating profit and net profit calculations.
You can calculate your net profit using this simple formula:
Sales - (Cost of Goods Sold + Allowable Expenses) = Net Profit
Put simply, net profit is your bottom line. It’s what’s left after you’ve deducted all your costs from your sales total — not just the cost of goods sold, but also other overheads and, usually, tax too.
In the UK, your expenses are allowable if you make them ‘wholly and exclusively’ for business purposes. HMRC considers this to be one of two things:
On your profit and loss statement, you can show net profit either before or after tax.
Let’s imagine you run a clothes shop and need to calculate your net profit by subtracting all your business costs from your gross profit.
You buy your stock from a wholesaler. Your annual takings come to £250,000, but you spend £100,000 with the wholesaler. Your gross profit is £150,000.
But this doesn’t take into account wages, utilities, rent, your National Insurance bill and more. If all this adds up to £50,000, your net profit would be £100,000 — £50,000 less than your gross profit.
So, what do we mean by profit margins? These are simply the gross profits and net profits expressed as a percentage. You can use these values to assess your business’s performance and to set targets.
Here’s how to work them out.
To calculate gross profit margin, divide gross profit by revenue and multiply by 100 to get a percentage. This is expressed as the following formula:
Gross Profit / Revenue x 100 = Gross Profit Margin
Let’s say your revenue is £300,000 and the cost of sales is £150,000.
To find the gross profit margin, you’d do as follows:
To calculate your net profit margin, divide your net profit by revenue and multiply by 100 to get a percentage. Net profit margin measures your profitability more accurately than gross profit margin because it removes all your expenses — including tax — from the calculation. You can express the net profit margin with the following formula:
Net Profit / Revenue x 100 = Net Profit Margin
Using the previous example, your revenue is £300,000 and the cost of goods sold is £150,000. You also made a further £50,000 in expenses.
So, to calculate your net profit margin, you would:
Of course, these are average values. Ultimately, what constitutes a ‘good’ profit margin is subjective and depends on several factors, including:
While you might be more than happy with your profit margin, it pays to make sure it stays healthy. A healthy profit margin means you’ll stay in business. And who wants to have to go back to the 9 to 5, right?
Here are a few tips to help you keep your profit margin on the up and up:
All clear? Now go make some profits.