How to Calculate Net Profit Margin: Definition & Formula

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  • 0:03 What Is Net Profit Margin?
  • 0:59 How Is Net Profit…
  • 2:11 Calculating the Net…
  • 4:25 !!!Lesson Summary
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Lesson Transcript
Instructor: Tara Schofield
This lesson discusses the importance of the net profit margin. The formula is explained and an example is provided that walks through the steps of calculating net profit margin.

What Is Net Profit Margin?

Net profit margin is a key factor in determining how financially strong a company is. It is a ratio that explains how much of the money a company earns showing how much of each dollar earned is retained by the company.

Because net profit margin is a measurement of income, the higher the net profit margin, the better. When comparing a company to its competitors, the best thing is to have a higher net profit margin than other companies in the industry. The higher the net profit margin, the better, meaning that for each dollar earned, a higher percentage of that dollar is kept for the business.

By comparing the net profit margin of his or her business to the industry standard or competitors' net profit margins, a business owner can make the best decisions and adjustments that allow the company to be more successful. It also helps find weaknesses or areas that can be improved in expense management.

How Is Net Profit Margin Calculated?

Before the net profit margin can be calculated, we need to know the net profit and revenue numbers. Revenue is the amount of money or income a company earns from normal business operations. Net profit is the amount of money left from the money (revenue) that comes into the business after the general expenses, manufacturing costs, interests, and taxes are paid.

There are two steps involved in the calculation of the net profit margin. The first step is the calculation of the net profit. Let's start with that calculation. The net profit is the amount of revenue left over after subtracting the cost of goods sold, otherwise known as COGS; the operating expenses; and the deduction of interest paid and taxes as well.

The formula for net profit looks like this:

Net profit = Revenue - Cost of Goods Sold (COGS) - Operating Expenses - Interest and Taxes

Once we have the net profit and revenue numbers, we can calculate net profit margin. The net profit margin is the net profit divided by the revenue.

Net Profit Margin = Net Profit / Revenue

Calculating the Net Profit Margin

Let's walk through this with an example. You own a bicycle shop in a town that has two other bicycle shops. To find how your business is doing financially compared to the other shops, you need to know how you are doing, compared with the others in town. After doing some research, you find that the other bicycle shops have a profit margin in the 19% - 22% range. However, you aren't sure if your business is more profitable than those shops are or not. That's where our calculations come in.

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