Businesses must report information about sales and profits or losses each accounting period on the firm's income statement. However, just listing the profit on sales may not tell you much about a company's performance. Businesses also calculate profit as a percentage of sales, which is referred to as the profit margin.
Profit margin calculations aren't difficult, but they're complicated by the fact that several profit figures appear on an income statement. They must be computed in a specific sequence, so the calculation is a multistep process rather than a single equation.
Each profit amount as reported on an income statement represents the amount remaining after certain costs and allowances are deducted from or added to sales. In this sense, the profit calculation formula is similar for all profit figures.
Starting with sales, you deduct direct costs (to make or acquire goods/services) to compute gross profit. Additional indirect cost amounts (rent, electricity, salaries) are subtracted to arrive at the operating profit. The pre-tax profit amount is often used interchangeably with operating profit; they are not always exactly equivalent, however. And finally net profit, which is sometimes called the "bottom line", after direct costs, indirect costs, and taxes are removed from the gross profit amount.
Likewise, there's a profit margin formula, which is sometimes termed a sales margin formula. The formula is the profit divided by total revenue and multiplied by 100 to express as a percentage. Simply choose the applicable profit figure to calculate as a percentage of sales.
Businesses calculate profit margins because they make it easier to assess company performance than relying on the actual dollar figures alone. Suppose you find the business records an operating profit margin of 30% one year and this falls to 25% the following year. This may indicate the firm is using its revenues less efficiently since more of each dollar is going to cover operating costs. Using margins also allows you to compare how efficiently companies of different sizes use their revenue dollars.
Gross profit is the first profitability figure that appears on an income statement. It equals sales less the direct costs required to acquire products for sale. In retail, direct costs are usually referred to as the cost of goods sold. Suppose the Acme Widget Company has $2 million in sales for an accounting period. If the cost of goods sold equals $1,100,000, subtracting this amount leaves a gross profit of $900,000. The gross profit margin is calculated as $900,000 divided by $2 million, with the result multiplied by 100 to express it as a percentage. Here, the gross profit margin equals 45%.
Operating profit is the next profit figure to be calculated. Operating profit equals the gross profit minus selling, administrative and general costs. Examples of operating costs include office salaries, advertising and office rent. For instance, the Acme Widget Company has operating expenses of $500,000. Subtract this amount from gross profit of $900,000 to find the operating profit of $400,000. Divide $400,000 by $2 million in sales to calculate the operating profit margin of 20%.
Pretax profit is the third profit item on an income statement. It's computed by subtracting financing expenses from operating profit. Miscellaneous items, such as interest earned on investments, legal judgments and other amounts not related to the firm's primary operations, are also added or subtracted. Suppose Acme Widget Company has net costs in this category of $100,000. Subtracting out from the operating profit of $400,000 leaves you with $300,000 in pretax profit. Again, divide by total sales of $2 million to calculate the pretax profit margin of 15%.
Net profit is the "bottom line," meaning the actual profit a business keeps after all costs are paid. You figure net profit by subtracting local, state and federal income taxes from pretax profit. If Acme Widget must pay a total of $100,000 in taxes, subtract this amount from the $300,000 pretax profit, which leaves $200,000 in net profit. Divided by $2 million in sales, this results in a net profit margin of 10%.