How to calculate profit margin: gross and net, worked through

How to calculate profit margin: the formula

Profit margin is the share of each sales dollar you keep as profit. To calculate it, take revenue, subtract the costs you are measuring, divide the result by revenue and multiply by 100 to turn it into a percentage.

The FDIC's Money Smart for Small Business course builds profit from a profit and loss statement, with this basic formula: Sales – Cost of Goods Sold = Gross Profit – Overhead = Net Profit. Gross profit is Sales less Cost of Goods Sold, and net profit is Gross Profit less Overhead. Each margin divides one of those profit lines by sales.

In the FDIC's definitions, cost of goods sold covers the cost of purchasing the items, freight, manufacturing costs, modification costs, and packaging. Overhead covers expenses associated with your ongoing business operation, such as rent or utilities. The table sets out the profit lines and the two margins side by side.

Use the same period and the same revenue figure for every margin you compare. The FDIC guide notes that a P&L statement measures revenue and expenses over a month, quarter or year, and calls it the best tool for knowing if your business is profitable. The guide defines sales, also called income or revenue, this way: Total amount from selling your product or service during a certain time period.

How to calculate profit margin percentage for a product

The steps follow the order of a profit and loss statement. The FDIC formula puts everything that is not cost of goods sold into overhead; these steps split out the fees and postage on each order, because they change with every sale.

1. Write down the selling price

   Use the price the buyer pays for the item. If you offer free shipping, the postage is inside this price and becomes one of your costs.

2. Add up the cost of goods sold

   Count the materials and packaging that go into one unit. Divide bulk supplies by the number of units they make, so a spool of wick or a case of jars becomes a cost per item.

3. Calculate the gross margin

   Subtract the cost of goods sold from the price, divide by the price and multiply by 100.

4. Subtract selling costs

   Take off the platform fees, payment processing and any postage you pay for the order.

5. Spread the overhead

   Divide monthly costs such as a store plan, software and equipment by the units you sell in a month, and subtract that share from each unit.

6. Calculate the net margin

   Divide what is left by the price and multiply by 100. That percentage is the net profit margin before income tax.

Worked example: profit margin on a handmade candle

Example: a seller makes soy candles and sells them on Etsy for $32 each, with free shipping. The inputs are example assumptions chosen to show the method, for a month in which the shop sells 60 candles and no order comes through Etsy's Offsite Ads. Your own costs will differ.

Example result: the candle looks very profitable at the gross level, yet fees, postage and overhead take about a third of the price before the seller is paid. Gross margin alone would hide that gap.

Net profit is not yet money to spend freely. In the FDIC's words, it is what remains to pay for expansion, equipment, loan repayment, income taxes and owner’s draw.

The example does not count the seller's own time as a cost. If you want the margin to cover a wage, add your hours per candle times an hourly rate as a cost line, and the net margin will fall by that amount divided by the price.

How platform fees change the margin on the same product

The same $32 candle sold on two marketplaces and two own-store builders, using each platform's published rates. Every dollar of fees comes straight out of net profit, so the place you sell changes the margin even when the price and the product stay the same.

Contribution margin and break-even: the SBA formulas

The SBA's guide to startup costs adds a third measure, used in its break-even analysis. Contribution margin is the difference between the price of a product and what it costs to make that product, and the SBA calculates it as (sale price per unit – variable cost per unit) ÷ sale price per unit.

Variable costs rise with every unit you sell: materials, packaging, fees and postage. Fixed costs are costs incurred during a specific period of time that do not change with the increase or decrease in production or services, such as a store plan or software. The SBA gives the break-even point in units as fixed costs ÷ (sales price per unit – variable cost per unit).

Example result: the first 9 candles each month pay the fixed costs, and each candle after that adds $14.51 to profit. The SBA says finding your break-even point will help you price your products smarter. Contribution margin helps when you decide whether a discount or a free-shipping offer still pays.

What is a good profit margin? Census retail benchmarks

A good profit margin depends on what you sell and how you sell it, so the most useful comparison is with businesses that sell the same kind of goods. The Census Bureau's Annual Retail Trade Survey published gross margin as a percentage of sales for each kind of retail business.

The survey covers all U.S. firms with paid employees that are primarily engaged in retail trade, and its final release holds employer-only estimates, so makers who sell without staff are not in these figures. The Annual Retail Trade Survey has since transitioned to the Annual Integrated Economic Survey (AIES), which makes 2022 the last year in its gross margin table.

These are gross margins, the same measure as the gross margin in the candle example. The table does not publish net margins, so it cannot tell you what a good net margin is. The miscellaneous store retailers group includes office supplies, stationery, and gift stores, which makes it the nearest of these groups to a gift or handmade shop.

A retailer's cost of goods sold is mostly the price it paid for stock. In the candle example, cost of goods sold is materials and packaging, with the maker's own time left out, so its gross margin sits well above these figures. A maker whose gross margin is close to a reseller's figure should check that the price covers the hours that go into each piece.

How much profit should you make on a product?

There is no single right number. Work back from the net profit you need: decide what the business must pay each month, including your own pay, then set a price that leaves that amount after every cost in the worked example.

To price from a target gross margin, divide the cost of goods sold by one minus the margin you want. Example: a product with $8.50 in materials and packaging and a target gross margin of 60% needs a price of $8.50 divided by 0.40, or $21.25.

Then run the net margin again at that price. Fees that are a percentage of the sale shrink with the price, while postage and overhead stay the same. Example: at $21.25, with the same Etsy fee rates, $5.50 postage and $2.00 overhead, the candle's net margin falls to 13.1%.

How to raise a thin profit margin

Margin moves when price moves or when a cost line moves. Work down the cost table first, then look at price.

• Buy materials in larger lots so the cost per unit falls, if the product sells fast enough to use them.
• Charge for postage, or build the average postage into the price, instead of absorbing it.
• Spread fixed overhead over more units, or cut tools you do not use.
• Raise the price, then check that the margin you planned is the margin you get.

Where Nation fits

Questions about profit margin