How and why to choose your profit margin calculation: gross, net or operating
Select the right profit calculation type to steer your business in the right direction
Deciphering profit can be a complex process. Ensure your numbers paint an accurate picture of your business’s financial performance.
Understanding different profit margin calculations
What is the most important metric for tracking business success? It’s not sales, but rather the percentage of sales that turn into profit.
In the realm of business finance, profit margin calculation plays a vital role in assessing the financial health of an organisation. While profit margin is a commonly used metric, it's important to understand the differences between the three primary calculation types:
- gross profit margin,
- net profit margin
- operating profit margin.
Each calculation offers uniquely nuanced insights into different aspects of a business's profitability. So, how do you identify which profit calculation type is best for your business? Which one will provide the insights you need to steer your business in the right direction?
In this article, we delve into the intricacies of each – exploring their formulas, advantages and disadvantages, as well as their suitability for different scenarios.
Profit calculation type 1: Gross profit margin
Gross profit margin represents the proportion of revenue that remains after deducting the cost of goods sold (COGS). It provides a broad overview of the profitability of a company's core operations, excluding other expenses such as operating costs and taxes.
Gross profit margin concentrates solely on the relationship between revenue and COGS. By analysing gross profit margin, businesses can assess their production and pricing strategies, as well as their ability to control direct costs. Higher gross profit margins indicate better efficiency in managing the cost of production.
Gross profit margin formula(Revenue - COGS) / Revenue * 100
- Provides insights into product pricing and production efficiency.
- Allows businesses to evaluate the impact of changes in direct costs.
- Helps identify opportunities for cost reduction and improvement in profit margins.
- Does not consider key operating expenses, such as salaries, utilities and marketing costs. A company with high expenses may have a low gross profit margin even if it is profitable.
- Does not factor in changes to sales volume. A company that experiences a large increase in sales may see gross profit margin decline, even if it is still profitable.
- Does not consider how much profit is generated by the core business. A company that earns significant profits from its investments, interest earnings, a legal settlement or other non-core business may have a low gross profit margin.
- Offers limited insights when comparing companies across different industries, because different industry sectors vary greatly in COGS.
Suitable for: Businesses (particularly product-centric) wanting to assess profitability in isolation of operating expenses.
Profit calculation type 2: Net profit margin
Net profit margin provides a comprehensive overview of a company's profitability after considering all operating expenses, including COGS, operating costs, interest payments, taxes and any other deductions. This metric reflects a business's overall ability to generate profits, taking into account the impact of taxes and interest payments. Higher net profit margins indicate effective cost management and revenue generation.
Net profit margin formula(Net Income / Revenue) * 100
- Offers a comprehensive view of a business's overall profitability.
- Incorporates all expenses, including COGS and operating costs.
- Helps assess the impact of taxes, interest and other non-operating expenses.
- Does not consider a company’s total expenses or always accurately reflect a company’s performance. A company may have a low net profit margin but have a high sales volume.
- Can be distorted by external factors like taxes, interest rates and one-off events – like selling an asset or setting up a new location.
- May vary across industries, making it less comparable.
Suitable for: Businesses wanting to evaluate their overall financial performance and profitability, irrespective of industry.
Profit calculation type 3: Operating profit margin
Operating profit margin, also known as operating margin, measures the profitability of a company's core operations by excluding non-operating expenses like interest and taxes. It helps evaluate a business's operational efficiency and profitability without the influence of taxes, interest and other non-operational factors. By assessing operating profit margin, businesses can determine the extent to which their core activities generate profit. Higher operating profit margins imply better management of operating costs and higher revenue generation from core operations.
Operating profit margin formula(Operating Income / Revenue) * 100
- Focuses on core operations, excluding non-operating expenses.
- Provides insights into the efficiency of a business's core activities, enabling potential investors to distinguish revenue channels.
- Helps identify potential areas for cost optimisation and revenue generation.
- Can be used to compare competitors within an industry, assessing how efficiently a company runs its operations in comparison.
- Enables comparison of a single profit margin across multiple quarters or financial years to determine whether a business is getting more profitable and efficient over time.
- Excludes non-operating expenses, which may impact overall financial health, and therefore not give a true picture of a company’s financial footing. A company could be suffering net losses while showing a positive operating income.
- May not account for industry-specific factors that affect profitability.
- Cannot be used as a single metric measure. Instead, it needs to be compared to other profitability ratios, between companies and over a period of time.
Suitable for: Businesses looking to assess the efficiency and profitability of their core operations, regardless of external factors.
Make sure your profit metrics paint an accurate picture
Selecting the appropriate profit margin calculation is crucial for gaining an accurate understanding of your business's financial performance. While gross profit margin emphasises production efficiency, net profit margin provides a broader view of overall profitability, and operating profit margin hones in on core operational effectiveness. By analysing these metrics, you can make informed decisions to optimise costs, enhance revenue generation, and ultimately drive long-term profitability. If in doubt, it pays to get advice from an expert accountant who can run the numbers for you.