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Running a business

Net profit margin: Definition, formula, and example

By QuickBooks Australia

Published on June 11, 2024

No matter the size of your business or the industry you’re in, keeping tabs on your profitability is key.

While having a good understanding of how much revenue you’re bringing in is important, it doesn’t tell the full story of your business’s financial health.

That’s because if you’re spending more money than you’re making, you’ll eventually run out of steam and lack the capital needed for long-term growth.

One useful metric you can use to assess your financial position is net profit margin.

This article covers the ins and outs of net profit margin, including how to calculate it, examples, and how to improve it.

What is net profit margin?

Net profit margin, also called net income margin or net margin, measures how much profit a business earns as a percentage of its revenue (sales).

In a nutshell, net profit margin tells you how much money is left after factoring in all business expenses. These include:

The cost of sales (COS)
Operating expenses
Interest paid on debts
Taxes

Net profit margin is generally represented as a percentage. For example, a net profit margin of 20% means a business keeps 20% of its revenue and spends the remaining 80% on business expenses.

When people refer to a business’s ‘bottom line’, they’re most often talking about net profit margin.

Why is net profit margin important?

Net profit margin helps you understand two important things.

Firstly, it tells you whether you’re earning enough revenue to cover your business expenses.

Secondly, it allows you to gauge whether your business expenses are manageable.

From there, you can make adjustments to help sustain a healthy profit.

For example, a low net profit margin might signal you should try increasing your prices slightly (to bump up revenue) or find a cheaper supplier (to reduce your cost of sales).

Investors will also often look at net profit margin, among other factors, when deciding whether or not to invest in a business. So if you’re looking for people to invest in your business, you’ll want to aim for a net profit margin that’s reasonable for your industry.

What’s a good net profit margin?

It’s a question a lot of business owners ask: what should my net profit margin be?

A healthy margin varies by industry and business size, so it’s worth doing some specific research to figure out the right benchmark for your business.

As a general rule of thumb, though, a 10% net profit margin is average, a 20% margin is high or ‘good’, and a 5% margin is low.

Net profit vs. gross profit margin

You might also come across gross profit margin as a business finance metric – but how does it differ from net profit margin?

As we’ve mentioned, net profit margin measures how much money is left after factoring in all business expenses.

Gross profit margin, on the other hand, measures how much money remains after accounting for the cost of goods only. This includes any costs directly related to creating a product or service, such as labour and material costs.

Gross profit margin can be helpful for specifically tracking how the cost of producing goods or services impacts profitability because it excludes expenses such as rent, taxes, and interest paid on debts.

Net profit margin formula

Net profit margin is calculated by dividing net profits (revenue minus expenses) by total revenue, then multiplying by 100 to convert it into a percentage.

Here’s the formula for net profit margin:

Revenue - expenses

–--------÷----------- x 100 = Net profit margin

Revenue

Net profit margin example

Let’s say your business makes $10,000 by selling candles. It costs you $4,000 in labour and materials to produce those candles. You spent another $4,000 on warehouse rent, taxes, and marketing for your candle business.

Here’s how to work out your net profit margin:

Revenue ($10,000) - expenses ($4,000 + $4,000)

–-------------------÷------------------------------ x 100 = 20%

Revenue ($10,000)

In this case, your net profit margin would be 20%.

What are the limitations of net profit margin?

Although net profit margin is a useful metric, it’s not the be-all and end-all when it comes to understanding the overall financial health of your business.

For example, a large one-off expense such as a repair or bulk material purchase could significantly impact your net profit margin over a certain period.

On top of that, net profit margin doesn’t necessarily equate to the amount of cash flowing into your business during a particular period. This means you could be short on cash even if your net profit margin is healthy, or vice versa.

That’s why, in addition to your net profit margin, it’s a good idea to analyse other reports such as cash flow statements to get a more complete picture of your business finances.

How to increase your net profit margin

If your net profit margin isn’t quite where you want it to be, don’t stress. There are many steps you can take to potentially boost your company's profitability, including:

Sharing office or warehouse space: Rent workspace part-time rather than full-time to help reduce a notoriously expensive business cost.
Increase prices: Bump up your prices if possible to boost revenue.
Upsell and cross-sell: Maximise your average order value by upselling and cross-selling.
Reduce material costs: Consider switching to cheaper suppliers or working out a deal with your current suppliers to reduce your cost of sales.
Cut low-margin customers: Identify customers with the lowest profit margins and aim to renegotiate costs or, if that’s not possible, drop them.

Reduce debt: Aim to pay off your debt to avoid spending money unnecessarily on interest payments.

Keep an eye on your finances

Analysing data regularly is crucial to lowering costs and finding ways to optimise your business's net profit.

With an accounting software like QuickBooks, you can check your net profit and other key reports in just a few clicks, and ensure your business is performing at its best.

Running a business

What is an invoice? A guide and what to include

June 26, 2024

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