How Do You Calculate Profit Margins in the UK?
Want to find out how much income you’re making for every pound spent? You need to calculate your profit margin.
As a business owner, the profit margin is an important metric to know. But while it should be simple to calculate in theory, it’s slightly complicated by having to talk about gross profit and net profit.
Here’s how you can calculate your small business’ profit margin step by step. We’ll also have a look at what a healthy profit margin should look like if your small business is based in the UK.
What’s the difference between gross profit vs net profit?
Gross profit is your sales revenue minus the cost of goods sold. By contrast, your net profit is your sales revenue minus the cost of goods sold and other business operating costs.
Let’s say you sell coffee:
- Your gross profit would be the difference between what you charge your customers for the coffee and what it costs you to make it.
- Your net profit would be what’s left over from your sales revenue after subtracting the cost of making the coffee as well as other allowable expenses.
We’ll delve into allowable expenses in more detail later. However, broadly speaking, they’d include expenses such as your employees’ salaries, the cost of renting your premises, marketing, business insurance and more.
What is turnover?
Some people confuse gross profit and net profit with turnover. But turnover is something different. Turnover is the amount of money your business makes over a particular period of time.
You can also refer to turnover as sales, revenue or income. Accountants generally take turnover to mean net sales — the amount of sales excluding VAT.
How do I calculate gross profit in the UK?
You can calculate your business’ gross profit using a simple formula:
Sales – Cost of Goods Sold = Gross Profit
What is the cost of goods sold?
The cost of goods sold is the amount of money you spend to produce your product. This is also known as the direct cost of sales. It includes
- The price of raw materials
- The cost of transporting the raw materials to your premises
- Production costs, for example, the utilities you use to power the equipment you need to make the product
- Labour costs
In simple terms, gross profit shows you how much value you’re getting from selling a product or service.
That said, it’s only a rough snapshot. Gross profit doesn’t take into account operating expenses (which you deduct to find your operating profit), tax, payroll and interest. For this reason, your gross profit could indicate you’re a multi-millionaire, but your net profit might tell a different story.
What’s the point of calculating gross profit?
Well, knowing your gross profit is valuable. You can use gross profit to figure out how much income you generate from your products or services. And you can then use this to work out if your profit margin is acceptable.
If you’re not happy with your gross profit, you might have to cut your production costs or increase your prices. It’s a useful step towards making savings.
If you’re happy with your gross profit but still have to make savings, this will tell you that the issues lie with overheads or taxation. You can identify these with your operating profit and net profit calculations.
How do I calculate net profit in the UK?
You can calculate your net profit using this simple formula:
Sales – (Cost of Goods Sold + Allowable Expenses) = Net Profit
Put simply, net profit is your bottom line. It’s what’s left after you’ve deducted all your costs from your sales total — not just the cost of goods sold, but also other overheads and, usually, tax too.
In the UK, your expenses are allowable if you make them ‘wholly and exclusively’ for business purposes. HMRC considers this to be one of two things:
- The only reason for the expense is that you have a business. For instance, you wouldn’t buy employers’ liability insurance unless you had a business and employees.
- If the expense is partly for personal use and partly for business purposes, you can specifically show which part of the expense you used for business purposes. An example of this would be a personal car which you also use for business travel. You can use an app like MileIQ to track your business mileage and you deduct it as an expense.
On your profit and loss statement, you can show net profit either before or after tax.
Calculating gross profit and net profit: Example
Let’s imagine you run a clothes shop and need to calculate your net profit by subtracting all your business costs from your gross profit.
You buy your stock from a wholesaler. Your annual takings come to £250,000, but you spend £100,000 with the wholesaler. Your gross profit is £150,000.
But this doesn’t take into account wages, utilities, rent, your National Insurance bill and more. If all this adds up to £50,000, your net profit would be £100,000 — £50,000 less than your gross profit.
How do I calculate profit margins?
So, what do we mean by profit margins? These are simply the gross profits and net profits expressed as a percentage. You can use these values to assess your business’s performance and to set targets.
Here’s how to work them out.
Calculating gross profit margin
To calculate gross profit margin, divide gross profit by revenue and multiply by 100 to get a percentage. This is expressed as the following formula:
Gross Profit / Revenue x 100 = Gross Profit Margin
Let’s say your revenue is £300,000 and the cost of sales is £150,000.
To find the gross profit margin, you’d do as follows:
- Deduct the cost of sales from your revenue to find gross profit. In our example, this would be £150,000 (£300,000 less £150,000)
- Divide your gross profit by your revenue. So, £150,000 divided by £300,000, which would give us 0.5
- Multiply your answer by 100 to get a percentage
- Your gross profit margin would be 50 percent
Calculating your net profit margin
To calculate your net profit margin, divide your net profit by revenue and multiply by 100 to get a percentage. Net profit margin measures your profitability more accurately than gross profit margin because it removes all your expenses — including tax — from the calculation. You can express the net profit margin with the following formula:
Net Profit / Revenue x 100 = Net Profit Margin
Using the previous example, your revenue is £300,000 and the cost of goods sold is £150,000. You also made a further £50,000 in expenses.
So, to calculate your net profit margin, you would:
- Deduct the cost of sales and expenses from your revenue to find net profit. In our example, this would be £100,000 (£300,000, less £150,000, less £50,000).
- Divide your net profit by your revenue. So, £100,000 divided by £300,000, which would give us 0.33.
- Multiply your answer by 100 to get a percentage.
- Your gross profit margin would be 33 percent.
What profit margin should a business make in the UK?
- 12.7 percent for private non-financial corporations
- 15.7 percent for manufacturing companies
- 17.2 percent for companies that provide services
Of course, these are average values. Ultimately, what constitutes a ‘good’ profit margin is subjective and depends on several factors, including:
- Your industry. For instance, the clothing industry has registered a 2 percent net profit margin so far in 2018. By contrast, companies in the construction industry have registered a net profit margin of just 4.6 percent.
- The size of your business. To calculate your net profit margin, you deduct your expenses from your revenue. As a result, the lower your expenses are, the bigger your profit margin will be. Small businesses tend to have lower expenses and, so, higher profit margins.
- Your goals. Do you just want your business to keep ticking over or do you have dreams of world domination? Depending on your answer, your profit margin could be fine as is or need to be higher.
- How long have you been in business? As a rule, the longer you’ve been in business, the higher your profit margin.
How do I keep my profit margin healthy?
While you might be more than happy with your profit margin, it pays to make sure it stays healthy. A healthy profit margin means you’ll stay in business. And who wants to have to go back to the 9 to 5, right?
Here are a few tips to help you keep your profit margin on the up and up:
- Keep your overheads as low as possible. Perhaps you could cut your electricity bill. Or switch to a cheaper insurance provider. Every little snip helps. You’d be surprised at how much difference even a one percent reduction in expenses can make to your bottom line.
- Look out for wastage. Are you ordering too much raw material and it’s going bad before you use it? Or maybe you’re producing more than you can sell? Either way, this is money down the drain.
- Keep your customers happy. According to research, repeat customers spend up to 5 times more than new customers. Treat them well.
- Read our article on the most profitable business industries of 2018 for more ideas to help you improve your small business’ profitability.
All clear? Now go make some profits.
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