How to calculate profit margin

The common margins both divide a profit figure by sales:

• Gross margin is gross profit divided by sales. It shows what is left of each sale after the direct cost of making it.
• Net margin is net profit divided by sales. It shows what is left after every business expense.

business.gov.au's glossary notes that margin is usually expressed as a gross margin percentage: how much of each dollar of sales is profit. The division itself gives a decimal, which many reports then convert to a percentage. Sales must be above zero, because a period with no sales has no margin to measure.

1. Choose the period and take its sales from the profit and loss statement, after refunds.
2. Take gross profit for the same period: sales less the cost of goods sold.
3. Divide gross profit by sales to get the gross margin.
4. Take net profit for the same period and divide it by the same sales figure to get the net margin.
5. Round both results the same way every time, so small movements are not lost or exaggerated.

Profit went up between the quarters, yet both margins slipped: each sale kept a little less. The cost of goods sold grew faster than sales, so the places to look are supplier prices, discounting and a shift towards lower-margin products.

Net margin comes out lower because net profit is what's left of gross profit once the overheads are paid, and both margins are divided by the same sales. The gap between the two margins is the overheads as a share of sales. That's why they can move separately: gross margin reflects prices and direct costs, while the gap reflects what it costs to run the business.

Sales grew by a tenth and the gross margin held at 0.60, so prices and the cost of framing materials kept step with each other. The net margin still fell by a third, from 0.15 to 0.10, because overheads rose by more than a fifth: over twice as fast as the sales that pay for them.

When net margin falls while gross margin holds, look at overheads first, such as a new lease, an extra staff member or a higher insurance premium. When gross margin slips and the gap stays the same, the cause sits in pricing, discounts, direct costs or the mix of products sold instead.

The same idea works for one item: take the selling price, subtract what the item cost, and divide the difference by the selling price. The cost must be the full cost of getting the item ready to sell, not just the supplier's price.

The discount looks small against the price but takes a much bigger bite out of the profit on the sale. business.gov.au's pricing guide notes that discounting affects the bottom line, and suggests making sure a discount still covers your costs.

Margin divides the profit on a sale by the selling price. Markup divides the same profit by the cost. For the product above at its usual price, the profit is the same amount either way, but dividing by the smaller cost figure makes the markup come out higher than the margin.

Mixing them up is expensive. If you mean to keep a certain margin but apply that figure as a markup on cost, the price comes out lower than you planned and each sale keeps less profit than intended.

Yes. A negative margin means the costs were bigger than the sales, so the period or the item made a loss rather than a profit. Reports and tables often show a negative margin in brackets, such as (0.05). Where it shows up tells you where to look:

• A negative gross margin means goods or services sold for less than their direct cost. Clearance sales, a supplier price rise not yet passed on, or work quoted too low can each cause it.
• A negative net margin alongside a positive gross margin means trading covered its direct costs but not the overheads.
• A negative margin on one product can be deliberate. business.gov.au's pricing guide describes loss leader pricing, where a product sells below cost to bring customers in and the loss is made up on other products, and warns that it can reduce profits if it isn't managed well.

At the other end, a margin can't reach the whole of the sale, 1.00 as a decimal, on anything that costs money to supply, because the profit can't be bigger than the sales it came from. A figure above 1.00 usually means the profit was divided by the cost instead of the price, which gives a markup, or that the sales figure is missing something.

• Use the same accounting method in both periods. Under business.gov.au's description, cash accounting counts sales and costs when money moves and accrual accounting counts them when they occur, which can shift results between periods.
• Classify direct costs the same way each period, or gross margin will move for reasons unrelated to trading.
• Keep income that isn't from trading, such as interest or a grant, out of sales.
• Compare like seasons, such as this December with last December, when trade rises and falls through the year.
• Work out margins for each product line as well as the whole business, so a thin-margin line can't hide behind the rest.

In a spreadsheet, give each period its own column, with rows for sales, cost of goods sold, gross profit, overheads and net profit. Work out the gross margin and net margin as formulas that divide by the sales row, and have them skip any period with no sales, which would otherwise produce an error.

For several products together, divide total gross profit by total sales. Averaging the margin column instead gives a small product the same weight as a large one, so the average can differ from the margin on the profit and loss statement.

Accounting software's profit and loss report supplies the same figures. If it can show each line as a share of sales, the gross profit line in that view is the gross margin, and the gap between it and net profit is the overheads' share.

A workable routine is to work out both margins each month once the profit and loss statement is ready, and each product line's margin every quarter. Keep the report, any changes you made to the sales or cost figures, and a note of how direct costs were sorted, so next year's figures are built the same way.

No single figure suits every business, so this guide doesn't give one. The margin a business needs comes from its own costs and plans, and you can work it out backwards: add the overheads you expect for the year to the profit you're aiming for, then divide by the sales you expect. The result is the gross margin your sales have to carry. Expected sales must be above zero.

At last year's gross margin of 0.36, the same sales would bring in 144,000.00 of gross profit, 16,000.00 short of what the plan needs. Closing that gap means lifting the margin, selling more, trimming the overheads in the plan, or settling for a smaller profit.

Then set the figure against your own history: the same period last year, the trend over several years, and the margin your budget assumed. A new business without a history of its own can build the same sum from quotes, its lease and its budget. business.gov.au's budgeting guide adds market research and industry benchmarking as ways for a new business to estimate its income and costs.

Keep the margin and the profit in view together. Profit is an amount; margin is that amount as a share of sales. Profit can grow while the margin shrinks, as the quarters example showed, and a wide margin on small sales may still fall short of the profit the plan needs.

A margin rises when the price goes up, the cost comes down, or sales shift towards products that keep more of each dollar. The table tests the first two on a single product.

Here the smaller change to cost lifts the margin a little further than the larger price rise, because a price rise also makes the sale it's divided by bigger. Together the two changes take the margin from 0.35 to 0.44 without selling a single extra bouquet, though a price rise only helps if customers keep buying at the new price.

• Price. business.gov.au's cash flow guidance asks whether prices could rise without losing business, and its pricing guide describes value pricing, which bases a price on what the product is worth to customers rather than on its cost alone.
• Direct costs. Ask suppliers for better prices, cut waste and spoilage, and check what freight adds. The same cash flow guidance says that if you change to a cheaper supplier, quality shouldn't suffer.
• Sales mix. business.gov.au suggests focusing on your most profitable customers, products or services. Selling more of the lines that keep more of each sale lifts the overall margin even when no single price changes.
• Discounts. The pricing guide suggests planning how and when you'll use discounts, so each one stays a decision rather than a habit.
• Overheads, for net margin. The cash flow guidance also suggests going over costs regularly and dropping any the business can do without.

A thin margin leaves little buffer against a slow month or a cost increase. business.gov.au counts low profit margins among its cash flow warning signs, and among the trends to look out for in a financial health check.

Its cash flow guidance suggests working out the margin your sales need to carry to pay for your costs. Its pricing guide suggests a yearly price check at minimum, sooner if costs or the market move, and names your accountant or a business adviser as people to ask for help with setting prices.