Profit margins are financial metrics that reflect the ratio between your profits and your revenue. They play an important role in many strategic decisions, such as those around pricing, product mix and cost management.
This guide explains what you should know about profit margins, including how they work and how to calculate them. It also explores what is a good profit margin across various industries—and practical ways to improve when yours fall short.
What Is a Profit Margin?
A profit margin is a financial metric that shows how much profit your business retains after subtracting certain costs. Typically expressed as a percentage of revenue, it can help you gauge how efficiently you turn sales into profit.
The three primary types of profit margin include:
- Gross profit margin: This shows how much revenue remains after subtracting the cost of producing or delivering your offering, commonly known as the cost of goods sold (COGS) or cost of sales. It can help you evaluate your pricing strategy and the efficiency of production.
- Operating profit margin: This measures how much revenue remains after accounting for production costs and operating expenses, such as office rent, marketing and administrative wages. It reflects the efficiency of your core business operations.
- Net profit margin: This captures how much revenue remains after covering all expenses, including interest, taxes, depreciation and amortization. It’s the ultimate measure of your company’s profitability.
Because profit margins are expressed as percentages, they’re easy to compare against competitor benchmarks, even when gross revenue differs. You can also track them over time to monitor performance trends, making them powerful tools for financial analysis.
How To Calculate Profit Margin
Calculating profit margin involves dividing a specific profit metric by revenue, then converting the result into a percentage. The only variable that changes is which costs you subtract when measuring profit.
Here are the formulas you can use for the three main profit margins:
Gross Profit Margin = (Revenue – COGS) ÷ Revenue × 100
Operating Profit Margin = (Revenue – COGS – Operating Expenses) ÷ Revenue × 100
Net Profit Margin = (Revenue – COGS – Operating Expenses – Non-Operating Expenses) ÷ Revenue × 100
Alternatively, you can pull gross profit, operating profit and net income from your income statement and substitute them for the portion of each formula in parentheses.
How To Determine Profit Margin: Examples
Let’s walk through a simple example using real numbers to show how to find profit margin in practice. Say you pull the following amounts from your income statement:
- Annual revenue: $1M
- Cost of goods sold: $600K
- Operating expenses: $250K
- Non-operating expenses: $50K
With these numbers in hand, here’s how to calculate gross profit margin:
Gross Profit Margin = ($1M – $600K) ÷ $1M x 100 = 40%
Next, here’s how to calculate operating profit margin using the operating profit margin formula:
Operating Profit Margin = ($1M – $600K – $250K) ÷ $1M × 100 = 15%
Lastly, here’s how you would use these numbers to calculate net profit margin:
Net Profit Margin = ($1M – $600K – $250K – $50K) ÷ $1M × 100 = 10%
As mentioned earlier, you can also streamline these calculations by pulling your $400K gross profit, $150K operating profit, and $100K net income directly from your income statement.
What Is a Good Profit Margin?
In general, a higher profit margin is better for your business. The more revenue you retain after covering expenses, the easier it is to build cash reserves that you can use to drive growth or weather unexpected costs.
However, what qualifies as a good profit margin depends significantly on the context. Factors like your business model, growth stage and market conditions all play a role.
For example, service-based businesses tend to have lower COGS than product-based companies due to their lack of physical inventory. As a result, they may target higher gross profit margins.
Similarly, early-stage startups often prioritize growth over immediate profitability. They may be willing to accept lower margins than established mid-sized businesses in exchange for growing their market share.
To show you how much these metrics can vary, here are the average profit margins for various sectors as of January 2025:
| Industry | Gross Profit Margin | Operating Profit Margin | Net Profit Margin |
| Advertising | 29.91% | 10.90% | 3.00% |
| Auto Parts | 15.21% | 5.10% | 2.27% |
| Business & Consumer Services | 33.70% | 12.11% | 7.09% |
| Computer Services | 24.14% | 6.06% | 4.15% |
| Education | 41.15% | 9.24% | 2.65% |
| Food Wholesalers | 15.36% | 2.67% | 1.34% |
| Homebuilding | 24.97% | 15.52% | 12.00% |
| Restaurant & Dining | 32.90% | 15.96% | 10.62% |
| Semiconductors | 58.59% | 29.71% | 19.96% |
| Transportation | 23.17% | 6.83% | 4.09% |
Source: NYU Stern School of Business
What Is a Good Profit Margin for a Small Business?
There’s no universal benchmark for what constitutes a good small business profit margin. However, many business owners aim for net profit margins in the low teens, depending on their business model.
Generalized guidelines can only tell you so much, but a 10% net profit margin is often considered healthy. Meanwhile, a net profit margin closer to 5% is typically seen as low, while one approaching 20% is usually viewed as strong.
Here are some specific factors that affect what’s realistic for your small business:
- Cash cycle length: Companies that wait longer to collect cash or carry inventory for extended periods generally need stronger margins. Thin margins combined with slow cash inflows can quickly create liquidity issues.
- Cost structure: Fixed costs weigh more heavily on companies with smaller revenue bases. Until you reach a certain scale, your operating margins may remain compressed even if your gross margins are healthy.
- Pricing power: Small businesses often lack the pricing leverage of larger brands, especially when revenue depends on a limited number of customers. This can limit your ability to pass along rising costs, allowing inflation to erode your margins.
As a small business owner, you should start to worry about profit margins when you feel your financial stability is at risk. Typical warning signs include cash flow management issues despite revenue growth and operating expenses growing faster than sales.
What Is a Good Profit Margin for a Large Business?
Company size typically doesn’t have the strongest correlation with net profit margin. The same general benchmarks often apply to large businesses: under 5% is low, around 10% is healthy, and close to 20% is relatively strong.
As a business scales, what changes is where profitability growth tends to come from. Smaller businesses often drive gains through gross margin improvements, while larger businesses are more likely to benefit from operational optimization.
This is because by the time your company reaches $10M–$25M in annual revenue, your core infrastructure is usually in place. You no longer need to invest in leadership, systems or facilities to create additional revenue.
As a result, each additional dollar tends to contribute more to profit, even if gross margins remain stable. In addition, operating profit margin often becomes a better key performance indicator (KPI).
In many cases, larger businesses strategically accept lower gross margins to support volume, customer retention or competitive positioning. Their strong procurement leverage and operational efficiency can offset thinner unit economics.
How To Improve Profit Margins
When profit margins fall short of expectations, your first step should be to determine whether a short-term or structural issue is to blame.
When the compression is due to something temporary, such as a large one-time expense, margins should recover naturally. However, if they remain down across multiple periods or worsen as revenue grows, there’s probably a more systemic cause.
To avoid financial instability that might threaten your business, it’s important to track down any such issues early. Here are some common ones to look for:
- Outdated pricing strategy: When your pricing fails to keep pace with increases in direct materials, direct labor and overhead, gross margins will steadily erode.
- Operational inefficiencies: Manual processes and poorly integrated systems can create bottlenecks that compress operating margins as you scale.
- Unfavorable product or service mix: When low-margin offerings dominate sales, revenue may rise while margins decline.
Once you’ve identified the underlying cause of your compressed margins, the path to recovery often becomes clear.
For example, if a low-margin product is dragging down profits, shift your mix toward higher-margin offerings. If operations are inefficient, consider leveraging technology to streamline manual work. If increased costs are eroding gross margins, try updating your pricing strategy or renegotiating with vendors.
When you find yourself consistently reacting to various margin-related issues, poor financial visibility may be the ultimate issue. Investing in forecasting can help you anticipate these pressures sooner and be more proactive about managing profitability.
Manage Your Profit Margins With Expert Support From Paro
Profit margins are critical financial metrics that should actively inform your strategic decisions. Understanding how to manage them as your business evolves and economic conditions shift is necessary for sustainable growth.
If you don’t have the financial expertise to navigate profit margins in-house, consider bringing in a fractional expert. An experienced FP&A or CFO professional can identify your key margin drivers and build a clear optimization roadmap.
Need help finding the right fit? Use Paro to connect with a fractional CFO whose skills and experience are tailored to your needs.
