Founders launch businesses for many reasons — to change the world, fix a problem, help people, make something better. But for the business to stick around, it must also accomplish another important goal: turn a profit (or, at least, be working towards profitability).
This is of even greater importance in the current macroeconomic environment, where venture funding is scarce and businesses need to be smart about spend. Operating a profitable business can provide a buffer from market turbulence and make the business more attractive to investors who, in recent times, are being more careful with their venture dollars.
Here, we’ll explain profit margin, how to calculate it, and how to identify what a “good” profit margin looks like based on the type of business you operate.
What is profit margin?
If profit is the portion of your revenue left over after you deduct business expenses — cost of goods sold (COGS), operating expenses (OPEX), etc. — profit margin is the percentage of its revenue after expenses. The higher the percentage, the greater the profit. A business with a 10% profit margin and $100K in monthly revenue would have a monthly profit of $10K ($100K x 10% = $10K).
In the business world, profit margin is viewed as a reflection of the effectiveness of the business’s pricing, how well it manages expenses, and how efficiently it produces and monetizes its product or service.
Note that there are three primary ways to calculate and analyze profit margin, and each is uniquely reflective of a company’s operating efficiency. Here’s a look at the three core analysis methods:
- Gross margin: Commonly referred to as the gross margin, this profit margin is typically used to determine the profitability of a specific product or service, rather than the entire business. The gross margin only considers your revenue and COGS, and can help you better understand whether you’re committing too much time or resources to a specific product or service, or if you need to revisit pricing.
- EBITDA margin: This form of profit margin reveals how effectively a business can turn revenue into profits after accounting for COGS and OPEX (rent, payroll, etc.), but not interest or taxes. The expenses considered in the EBITDA margin analysis are the costs associated with keeping the business up and running. As such, EBITDA margin is considered a more accurate measurement of profitability than gross margin, but not quite as precise as net margin.
- Net margin: Often referred to as the net margin, this profit margin measures profit as a total percentage of revenue. The net margin takes into account all operating and non-operating expenses (COGS, OPEX, interest, taxes) to provide insight into the efficacy of the business model and forecast future profits. Net margin is considered one of the best indicators of a company’s profitability because it accounts for all expenses.
As you go from gross margin, to EBITDA margin, to net margin, note that each measurement includes an increasing number of business expenses. This means your net margin will typically be reflected as lower than your gross or EBITDA margin — but it also means that this measurement is the most holistic and accurate indicator of profitability.
How do you calculate profit margin?
Because each specific profit margin factors in unique business expenses, the equations to calculate each of the three margins are different. Here’s an overview of the formula for each profit margin:
To determine the gross margin, subtract COGS from revenue, then divide that number by the revenue. The formula is as follows:
Gross margin = ([revenue - COGS] / revenue) x 100
For example, if you have a product or service that you sell for $100, and the COGS of that product or service is $80, you’d have a gross margin of 20% — or, ([$100 - $20] / $100) x 100 = 20%.
EBITDA stands for earnings before interest, depreciation and amortization expenses. As such, EBITDA margin is specifically focused on operating profit and cash flow. It’s calculated by subtracting COGS and OPEX from revenue, and then dividing that number by revenue. The formula is as follows:
EBITDA margin = ([revenue - COGS - OPEX] / revenue) x 100
A business with annual revenues of $1M but $850K in combined COGS and OPEX would have an EBITDA profit margin of 15% — or, ([$1M - $850K] / $1M) x 100 = 15%.
The net profit margin is measured by subtracting a business’s total expenses from its total revenue, and dividing the result by the business’s total revenue. The formula is as follows:
Net profit = ([revenue - COGS - OPEX - interest - taxes] / revenue) x 100
If, for example, your business generated $500K in revenue last year and the sum of all expenses, interest paid, and taxes came out to $450K, your net profit margin would be 10% — or, ([$500K - $450K] / $500K) x 100 = 10%).
What does a healthy profit margin look like for your startup?
A “good” profit margin — or at least a standard one — is something of a fallacy given that it’s entirely dependent on the nature of your business. Generally speaking, a margin between 7–10% is usually considered healthy. But factors like you company’s industry, size, age, location, and particular growth goals are all part of the bigger story around your margin.
In light of these nuances, understanding benchmarks relevant to your industry can be a good place to start when considering a healthy margin for your business. A good resource here is a January 2023 analysis from NYU Stern School of Business, which outlines profit margin benchmarks for various business sectors in the U.S. After analyzing 7,165 businesses across the U.S. market, NYU calculated an average net margin of 8.89%. However, various sectors deviate from this average. For example, businesses in banking and financial services boast net margins north of 26%, while retail sectors produce margins between 0–9%.
These variations can be attributed to the economic factors of each industry. Financial services tend to have few operating costs and no inventory, allowing them to generate higher profit margins. Retail businesses, on the other hand, typically have a higher COGS and OPEX, which lowers their profit margins. This isn’t to say retail is a bad business — it’s just a different kind of business. While the gross margin may be low, many retail businesses do a higher volume of transactions compared to financial services. This allows them to generate enough revenue to justify a lower margin.
The age of the business also plays a role in profit margin. As many startup founders know, it’s hard to turn a profit in the early days of starting a business. Founders often try to invest in growth in order to put their companies on the path towards future profitability. This is particularly common for SaaS startups, where COGS and OPEX are low aside from the cost of labor.
That said, younger businesses can sometimes have a higher profit margin than large businesses because of lower costs. A 50-person startup may have fewer sales than a large firm with thousands of employees, but it also has lower OPEX. As the business expands, its margins usually shrink, even as revenue increases.
Geography also plays a role in profit margin because the costs of labor, rent, and utilities tend to vary based on where your business is located and primarily operating out of. A startup in San Francisco or New York will likely have to pay a lot more for talent than a mom-and-pop-shop in Iowa.
As you start to take in all of the variables and layers of information that inform profit margin, it becomes clear why there’s no such thing as a one-size-fits-all “good” margin to strive for. One business’s “bad” profit margin is another’s best quarter ever. It all comes down to figuring out what makes sense in the context of your business, and working your way to profitability with that in mind.
If you’re looking for a banking1 partner that can put your business on the path to profitability, consider Mercury. Mercury works with startups across a variety of sectors to more effectively manage spend and hit their growth goals. To learn more, visit our website.