Q: What are profit margins? How do I calculate them?
–B. Turner, Union City, CA
A: Profit margins measure how much money a company keeps after factoring in the cost of doing business (expenses). Since you want to remain profitable, you’ll have to pay close attention to margins because you need them to be as high as possible.
There are different kinds of margins. Gross margin is the percentage of a revenue dollar remaining after a company has paid for labor and materials. Operating margin shows what is left of that same dollar after subtracting out everything but taxes and one-time charges. Direct costs margin is generated after paying for costs that are directly associated with the product or service being sold. The net profit margin is the percentage of a revenue dollar that a business keeps after all the bills are paid. Since net profit margins are the most commonly used and affect the bottom line the most, we’ll focus on this.
Calculating net profit margins requires basic mathematics. Let’s say you own a retail store that sells a particular product for $100 and the manufacturer charges you $60 for that same item. The profit would appear to be $40. But after you factor in overhead and operating costs (rent for the store, labor, and taxes), that number will surely drop. So to calculate your profit margins, take the selling price ($100) and subtract the price you paid to acquire that product ($60), as well as operating costs and overhead (let’s say it averages out to $15). Now divide that by the selling price (again, $100). This results in your profit margin (100-60-15÷100=0.25 or 25%).
That’s a very basic explanation, but it should give you an idea.