Net Profit Margin

In one sentence: Net profit margin says how many cents of profit a business keeps from each dollar of sales, after every cost has been paid.

$\text{Net profit margin} = \frac{\text{Net income}}{\text{Revenue}}$

Read it out loud: “Net profit margin equals net income divided by revenue. Net income is the profit left after every cost, interest and tax is paid. Revenue is the total money from sales. Dividing the two gives the share of each sale that is kept as profit, usually written as a percent.”

Before you start

The ideas and signs this page uses, explained from zero. For powers of ten, Greek letters and other notation in general, see Math basics.

Revenue and sales: Revenue, also called sales, is the total money a business takes in from selling its goods or services over a period. It is counted before any costs are taken away. A bike repair shop that charges 60000 dollars across a year for repairs and parts has 60000 dollars of revenue for that year. Revenue is the top of the story, and every cost comes out of it afterwards.
Costs and expenses: A cost is money spent to run the business, such as parts, wages, rent, insurance and electricity. Costs are taken away from revenue in steps. The cost of goods sold is the cost of the items actually sold, such as the spare parts fitted into bikes. Other costs, such as rent and wages, are called operating expenses, and they are paid whether or not a particular item sells.
Net income: Net income, also called net profit or the bottom line, is what is left after all costs, interest and taxes have been subtracted from revenue. It is the real profit for the period. If it is negative, the business made a loss. The word net means after everything has been taken away, which is why it is the strictest kind of profit.
Fractions and percents: A fraction is one number divided by another. A share like 9000 out of 60000 is written as $\frac{9000}{60000}$ , which equals 0.15. A fraction is a share of one whole, so 0.15 means 15 parts out of every 100 parts. Multiplying a fraction by 100 turns it into a percent, so 0.15 becomes 15%.

What each symbol means

Symbol	Meaning
$\text{Net profit margin}$	The net profit margin, the share of revenue that is kept as profit after all costs. It is a ratio, so it has no money unit, and it is usually shown as a percent. In the example it is 0.15, which is 15%.
$\text{Net income}$	The profit left after every cost, interest and tax has been paid, measured in dollars over the period. In the example the bike shop has 9000 dollars of net income for the year.
$\text{Revenue}$	The total money from sales over the same period, measured in dollars. In the example the shop’s revenue for the year is 60000 dollars. Net income and revenue must always cover the same period.

The formula piece by piece

$\text{Revenue}$: Start with the money coming in. Revenue is the total sales over the period, before any costs are taken away.
$\text{Net income}$: Next, the money left after every cost. Net income is revenue minus all costs, interest and taxes, which is the profit the owner keeps.
$\frac{\text{Net income}}{\text{Revenue}}$: Divide the profit by the revenue. The result is the share of each sale that is kept as profit, a fraction you can turn into a percent.
$\text{Net profit margin} = \frac{\text{Net income}}{\text{Revenue}}$: The whole formula in one sentence: the net profit margin equals net income divided by revenue, which is the share of sales that a business keeps as profit.
$\text{Gross margin} = \frac{\text{Revenue} - \text{Cost of goods sold}}{\text{Revenue}}$: The gross margin, another common form. It takes away only the direct cost of the goods sold, so it shows the share of sales left after the cost of the items and before the overheads.

What the formula is doing, and why

The net profit margin answers one question: out of every dollar a business takes in, how many cents does it keep as profit? Revenue is the whole amount coming in. Net income is what remains once every cost has been paid. Dividing the one by the other gives the kept share of each dollar of sales.

Why divide by revenue? Profit on its own is hard to compare. A shop with 9000 dollars of profit may be doing well if its sales were 60000 dollars, but poorly if its sales were 900000 dollars. Dividing by revenue turns the profit into a share, so a small shop and a large shop can be compared on the same scale. Here the share is 15% for the small shop and 1% for the large one.

Why net and not gross? Net income is the bottom line, after all the expenses, interest and taxes. It is the strictest version of profit, so the net margin is usually the smallest of the margins a business reports. Using net income tells you what the owner actually keeps from each sale.

Gross margin, the first step down. The gross margin uses gross profit, which is revenue minus the cost of goods sold. It shows how much is left from sales after the direct cost of the items, but before rent, wages and other overheads. Gross margin is usually bigger than net margin, because it stops before those other costs are taken away.

Reading a margin. A higher margin means more profit is kept from each sale, but the right level depends on the business. A supermarket can live on a small margin because it sells a great many items, while a specialist shop may need a bigger margin because it sells fewer. Compare a margin with others in the same industry before deciding whether it is good.

An everyday picture

Think of a paycheck. The pay is the revenue, the bills and groceries are the costs, and what is left after the last bill is the net income. If you keep 300 dollars of a 2000 dollar paycheck, you keep 15% of your pay. That share, 300 divided by 2000, is your personal net margin. It tells you more about how well your budget works than the 300 dollars would on its own, because it shows how much of each dollar you earned you get to keep.

Worked example: Profit margins for a bike repair shop

A bike repair shop earned 60000 dollars of revenue over the year from repairs and from the parts it sold. The cost of the spare parts it fitted and sold, the cost of goods sold, was 18000 dollars. Its other costs for the year, including rent, wages, insurance, loan interest and tax, came to 33000 dollars. All the figures are made up for illustration. We want the gross margin and the net profit margin.

Find the gross profit. Gross profit is revenue minus the cost of the parts sold, so $60000 - 18000 = 42000$ dollars. This shows what the shop kept from repairs and parts before any rent, wages or other overheads were paid.
Find the gross margin. The gross margin is gross profit divided by revenue, so $\frac{42000}{60000} = 0.7$ . As a percent that is 70%, so the shop keeps 70 dollars of every 100 dollars of revenue before its other costs are paid.
Find the net income. Net income is the gross profit minus all the other costs, including the tax, so $42000 - 33000 = 9000$ dollars. This is the profit the owner can actually keep for the year, after every bill has been paid.
Divide the net income by the revenue. The net profit margin is $\frac{9000}{60000} = 0.15$ . The answer is a fraction less than one, because the profit is smaller than the revenue, and 0.15 means 15 parts out of every 100 parts of revenue.
Turn the decimal into a percent. Multiplying by 100 moves the decimal point two places to the right, so $0.15 \times 100 = 15\%$ . The shop keeps about 15 dollars of profit from every 100 dollars of sales, after its rent, wages, insurance and tax are paid.
Compare the two margins. The gross margin of 70% is much bigger than the net margin of 15%. The difference, 55 percentage points of revenue, is the other costs taken together: 33000 divided by 60000 is 0.55. The gap shows where the money goes after the parts are paid.

Answer: The gross margin is 70%, and the net profit margin is 15%. The shop keeps about 15 dollars of profit from every 100 dollars of repair and parts sales, after rent, wages, insurance and tax are paid.

The numbers in this example are recomputed by script every time the site is built.

Common mistakes

Dividing by the wrong number, such as net income divided by the cost of goods sold, or profit divided by profit. The denominator is always revenue.
Using gross profit as the top number when the question asks for the net margin. Gross profit has not yet paid rent, wages or tax, so dividing it by revenue gives the gross margin, not the net one.
Mixing periods, such as a year of revenue with a single month of net income. Both figures must cover the same period, or the answer means nothing.
Comparing a margin from one industry with a margin from a very different one. Grocery stores and software companies have very different typical margins, so compare like with like.

Where you will meet it

Comparing the profitability of companies in annual reports and stock analysis, usually against other firms in the same industry.
Checking whether a business can afford to cut prices, because a thin margin leaves little room for a fall in sales before the business starts to lose money.
Small business planning, where an owner wants to know how much of each sale is kept after every cost is paid.
Deciding how much a price change would add to profit, since the margin shows the share of each extra dollar of sales that is kept.

Questions people ask

What is the difference between gross margin and net margin?

Gross margin takes away only the direct cost of the items sold, so it shows the margin on the product itself. Net margin takes away every cost, including rent, wages, interest and tax, so it shows what the owner really keeps. Net margin is usually the smaller of the two.

Is a higher margin always better?

A higher margin means more profit from each sale, but it can also mean fewer sales, because high prices may put customers off. A business with a lower margin and many sales can earn as much profit overall. Look at the margin alongside the total profit and how both change over time.

Why divide by revenue and not by the costs?

The margin asks what share of the money coming in is kept. Revenue is the whole amount coming in, so it is the natural base for the share. Dividing by costs would measure something else, such as how much profit each dollar of cost produces.

Break-Even Point: The break-even point says how many items you must sell before the money from sales has paid back all your fixed costs, so you stop losing money.
Markup: Markup says how much a seller adds on top of what an item cost, measured as a share of that cost.
Return on Equity (ROE): Return on equity tells you how many cents of yearly profit a business earns for each dollar its owners have in it.