Profit margin calculations compare business revenue with business profit after various expenses. Managers and investors use profit margin calculations to compare the profitability and cost-efficiency of differently sized companies. Net profit margin and gross profit margin are the two most commonly used profit margin calculations.
Net Profit Margin
Net profit margin is calculated by dividing net profits by net sales. Net sales are total sales less sales deductions such as allowance for sales returns. Net profit is net sales minus operating expenses. For example, consider a company that has net sales of $5,000 and net profit of $3,000. The net profit margin is 0.6, or 60 percent. The higher the ratio, the more profit a company makes relative to sales.
Gross Profit Margin
In contrast to the net profit margin method, the gross profit margin is equal to gross profit divided by revenue. Revenue is the total amount of money a business earns from business activities. Gross profit is equal to total sales revenue less cost of goods sold. For example, a business with $10,000 in revenue and $5,000 in gross profit has a gross profit margin of 0.5, or 50%. The higher the ratio, the more profit a business keeps relative to product and service costs.