There are several types of profit, and thus there are several ways to calculate profit margin. Profit is generally understood to be an enterprise's revenues less all the costs and expenses involved in earning that revenue, but to determine an enterprise's efficiency, other understandings of profit are meaningful. Two of the more commonly known forms of profit are gross profit and net profit. Gross profit is the revenue from sales less the cost of goods sold (COGS); net profit is gross profit less overhead items such as rent and taxes.
Gross profit is frequently a more reliable indicator of an enterprise's profitability, because it involves primarily those cost items over which the enterprise has a great deal of control, especially the costs, including labor, of converting raw materials to the state in which they're sold. Net profit is a less reliable indicator of the enterprise's actual profitability because it reflects many factors generally beyond the enterprise's control, such as rentals and costs associated with distribution.
An easy way to calculate profit margin based on gross profits is first to calculate the gross profit by determining the COGS and subtracting it from total revenues. The result is the gross profit. The gross profit margin is the ratio of gross profit divided by total revenues. For example, if an enterprise has annual total revenues of $1,000,000 US Dollars (USD), with COGS of $750,000 USD, the gross profit is $250,000 USD and the gross profit margin is 25 percent ($250,000 / $1,000,000).
To calculate profit margin based on net profits, or the net profit margin, all other costs associated with the enterprise must be accounted for. Thus, using the above example, if rents, taxes, utilities, and all other expenses total $110,000 USD, then the net profit for the year is $140,000 USD. To calculate profit margin based on net profit, divide the net profit by the total sales ($140,000 / $1,000,000), for a result of 14 percent.
There are other measures of profitability, each of which requires calculating profit margin in a slightly different manner. For example, earnings before interest, taxes, depreciation, and amortization (EBITDA) is a particular method of calculating profit margin excluding all costs not incurred by the enterprise's actual operation. EBITDA became a popular measure of profitability in the last two decades of the 20th century because it essentially was a way to calculate profit margin on a cash basis, without the inclusion of any accounting accruals or other costs beyond the enterprise's immediate control.
These different measures of profitability are important to investors because they're considered to be better indications of a business' viability than net profit margins, which include costs not directly related to the enterprise's operation. For example, if two competing companies have identical net profit margins, but one is paying taxes at a higher rate than the other, the tax payments lead to a distortion of the enterprises' actual profitability. The removal of the tax payments from the calculation of profit margin will disclose that the company paying the higher tax rate actually was more profitable.
