One of the indicators that help to understand the evolution of a business is the profit it generates. For entrepreneurs, it is not enough to know what the month's turnover was and assume that what is left, in the end, is profit or profit margin and that we are going to calculate. It is necessary to know how to calculate the gross margin and the net margin, to have a more accurate view of how much the company earns from the sale of products or services.
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What is the Profit Margin
At the beginning of a business, the most basic question that arises is whether the business, from an economic point of view, is or is not evolving positively, leaving for later the financial point of view.
It is common to consider that the profit margin is the difference between the money received from the sale of products or services and the expenses we incur in order to sell them.
But this margin can be divided into two parts, known as the gross margin and the net margin, depending on the type of costs that are considered.
The types of costs existing in the company
The costs or the value of the expenses that we have to calculate and evaluate over time, are the costs necessary for us to be able to carry out the business, be it the provision of services or the manufacture of any type of product.
An example that we presented, and that can be seen in more detail, is the catering business. You can learn more in this article about the business plan, what is it for and how to do it.
If we have a service business, we list all the expenses we make in a month or, if any, quarterly, half-yearly or annual expenses and we convert them into monthly averages.
If the business is providing services and if we intend to bill the services by the hour or by the day, just divide this average monthly cost by the number of days or hours in the month.
However, all businesses have costs that depend on the activity, for example in catering, the more dishes we sell, the more raw materials we consume. These costs that's why variables.
But there are costs that, regardless of whether the activity is large or small, we have to bear, such as rent, equipment rental, various insurance, maintenance of facilities or equipment, electricity, water, telecommunications, among others. They are the fixed costs of business.
These two types of costs mark the difference between the gross margin and the net margin.
If what we sell are products, for example in catering, divide the cost by the number of products manufactured, we will know the cost per unit. In this example, the number of products sold is difficult to determine if there is a wide variety, but if they are relatively homogeneous, for example menu dishes that have similar prices, we can use this value. If on average we serve 50 dishes a day, then multiply the unit cost value by the number of days we are open and we have the monthly cost. For example, 50 dishes daily x 30 days x €10 average cost per dish = €15.000 cost per month.
On the contrary, if we know the monthly costs in a service activity,
Service Unit Cost = Monthly Costs / No. of Monthly Services
If the costs considered in this calculation are variable, fixed or total, then we will also have fixed, variable or total unit costs of the service or products.
Two ways to calculate Gross and Net Margin
Simply put, after calculating the costs, we apply the % of the intended profit and find out the profit margin.
In possession of fixed and variable costs, we can know the gross margin and the net margin, instead of having an idea of profit margin that does not differentiate between the costs included therein.
1- Foresee what % of profit you want to have
The first way to calculate it will be, for example, we have a monthly cost of €5.000 and we want to have a gross margin of 50%. That is:
Profit Margin = €5.000 x 50% (0,5) = €2.500
So we will have to sell on average per month:
Sales = €5.000 + €2.500 = €7.500
Note that 50% represents 0,5, that is, half (50%) of the unit (100%).
The value of the sale is also arrived at by multiplying the value of the costs by 1,5 (1+0,5), that is, €5.000 x 1,5 = €7.500
This will be the public sale price (PVP) per month.
2 – Calculate what we want to earn
The second formula is based on the results. That is, we will have to calculate what we want to earn and then divide it to obtain the exact amount that we must apply.
So, if we want to earn a gross salary of €2.500 per month, we would have to get the number of monthly services we do.
Then divide the gross salary by the number of services.
If we do 50 monthly services, our account should be divided by 2.500€ by 50, resulting in 50€. However, if the average cost we have to incur to carry out each service is €25, we would have to charge €75,00 (€50+€25) to guarantee the intended monthly income.
Gross Margin and Net Margin - Summary
The gross margin uses the variable costs that, in the restaurant example, we calculated as the production costs ou cost of goods sold and materials consumed - CMVMC.
For the net margin, in addition to variable costs, fixed costs must also be considered, commonly known as Supplies and external services.
In short,
Gross Margin = Sales - Cost of Goods Sold and Materials Consumed
Net Margin = Sales – (Variable Costs + Total Fixed Costs)
To say that we are going to calculate the profit margin is an oversimplification, because there are actually two types of margins that you need to recognize and analyze.
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