How to measure profitability: profit margin formulas

Published Friday 17 April 2026

Table of contents

• What profitability means in small business
• Profitability metrics
• How to measure profitability
• Where to find the numbers you need
• Why measuring profitability regularly matters
• How Xero helps you measure profitability
• How to improve profitability
• Measure profitability with confidence
• FAQs on measuring profitability

Key takeaways

• Calculate your gross profit margin by subtracting cost of goods sold from revenue, then dividing by revenue and multiplying by 100 to track how much money covers direct production costs.
• Track your net profit margin monthly or quarterly by dividing total profit (after all expenses) by revenue to spot problems early and maintain healthy cash flow.
• Use your profit and loss statement to find the numbers you need, with revenue at the top, cost of goods sold below that, operating expenses in the middle, and net profit at the bottom.
• Improve low profit margins by raising prices to reflect true costs, negotiating better supplier terms, cutting operating expenses, or increasing sales volume without proportionally raising costs.

What profitability means in small business

Understanding profitability is essential for any small business owner.

Profitability measures how effectively your business turns sales into profit. The main profitability metrics are gross profit margin and net profit margin, which show what percentage of revenue you keep after paying costs.

High profitability means you retain a large share of sales as profit. This is generally positive, though it may signal room to lower prices and boost sales volume.

Low profitability means most of your revenue covers expenses. This could indicate high costs, underpriced products or services, or a competitive market where price pressure is constant.

Profit versus profitability and their significant differences

• Profit: the amount of money your business keeps after paying expenses
• Profitability: the percentage of revenue you retain versus the percentage spent on operations

This distinction matters. High profitability only improves your bottom line when paired with strong revenue. You need both healthy margins and solid sales to grow.

Profitability metrics

Profitability metrics are key performance indicators (KPIs) that show how efficiently your business converts revenue into profit. The two most common are gross profit margin and net profit margin, sometimes called profitability ratios.

Gross profit margin

Gross profit margin measures the percentage of revenue remaining after you pay direct costs, known as the cost of goods sold (COGS). These include materials, labour, and other expenses directly tied to delivering your product or service.

• What it shows: how much revenue covers direct production costs
• Why it matters: gross profit funds your operating expenses like rent, marketing, and administration

Net profit margin

Net profit margin measures the percentage of revenue remaining after paying all business costs, including operating expenses, interest, and depreciation.

• What it shows: your true bottom-line profitability
• Why it matters: net profit is what you reinvest in growth or distribute to owners

Net profit can be quoted before or after taxes. The calculations below use pre-tax net profit.

Operating profit margin

Operating profit margin measures the percentage of revenue remaining after paying both direct costs and operating expenses, but before interest and taxes. It shows how efficiently you run day-to-day operations, though its calculation can vary; one study found that companies used at least nine different ways to calculate operating profit.

• Formula: (Revenue − COGS − Operating expenses) ÷ Revenue × 100
• When to use it: if you want to assess operational efficiency separately from financing costs

For most small businesses, gross and net profit margins provide sufficient insight. Operating margin is useful when you want a more detailed view of how well you manage overhead costs.

How to measure profitability

To measure profitability, divide your profit by revenue and multiply by 100 to get a percentage. The calculation differs slightly depending on whether you're measuring gross or net profit margin.

First, calculate your profit figure. Then apply the formula for the margin you want to track.

How to calculate gross profit margin

Follow these steps to calculate gross profit margin:

1. Find your total revenue for the period.
2. Subtract your cost of goods sold (COGS) from revenue to get gross profit.
3. Divide gross profit by revenue.
4. Multiply by 100 to get a percentage.

Use the gross margin calculator to run the numbers automatically.

How to calculate net profit margin

*Net profit can be quoted before or after taxes. If quoting after-tax net profit then you need to also subtract taxes.

1. Find your total revenue for the period.
2. Subtract all expenses (COGS, operating costs, interest, depreciation) from revenue to get net profit.
3. Divide net profit by revenue.
4. Multiply by 100 to get a percentage.

Use the net profit margin calculator to run the numbers automatically.

Here's a practical example showing how these calculations work.

Example: Measuring profitability for a small business

Here's how to calculate profitability for a business with $100,000 in sales, $60,000 in inventory costs (COGS), and $20,000 in general expenses.

• Gross profit: $100,000 revenue − $60,000 COGS = $40,000
• Gross profit margin: $40,000 ÷ $100,000 × 100 = 40%
• Net profit: $100,000 revenue − $80,000 total costs = $20,000
• Net profit margin: $20,000 ÷ $100,000 × 100 = 20%

This business keeps 40 cents of every dollar after direct costs and 20 cents after all expenses.

Now that you understand the calculations, you need to know where to find the data.

Where to find the numbers you need

You'll find the numbers you need on your profit and loss (P&L) statement, also called an income statement. Here's where to look:

• Revenue: the top line of your P&L, showing total sales for the period
• Cost of goods sold (COGS): the section below revenue, covering direct costs like materials and production labour
• Operating expenses: the section including rent, utilities, marketing, salaries, and administrative costs
• Net profit: the bottom line after all expenses are subtracted

If you use accounting software like Xero, these figures are calculated automatically. You can pull a P&L report for any date range and see your margins at a glance.

Why measuring profitability regularly matters

Regular profitability tracking helps you spot problems early and make adjustments before margins erode. When profitability drops, cash flow often follows, making it harder to cover expenses and invest in growth.

Your margins can shift due to factors outside your control:

• rising costs for materials, energy, or transport
• changes in interest rates or rent
• currency fluctuations affecting import costs
• increased competition driving prices down

Measuring profitability monthly or quarterly helps you respond quickly to these changes and maintain healthy margins.

How Xero helps you measure profitability

You can automate profitability tracking so you don't have to calculate margins manually. While many businesses are embracing this type of automation, broader tech adoption has room to grow, with 83% of small businesses not using advanced tools like artificial intelligence. Xero calculates your gross and net profit margins automatically based on your transactions.

Here's how to access your profitability data in Xero:

• Xero Analytics: select any date range to see margin trends over time
• Profit and loss reports: generate a P&L statement to view revenue, costs, and profit figures
• Dashboard insights: check real-time profitability from your main dashboard

Automated tracking means you always have current data without manual spreadsheet work.

Once you understand your current margins, you can take steps to improve them.

How to improve profitability

Track your profitability regularly, especially when costs change or competition intensifies. Set a target margin for your business and use it as a benchmark. An accountant or bookkeeper familiar with your industry can help you understand typical margins and set realistic goals.

If your margins are lower than expected, you have several options:

• Raise prices: adjust pricing to reflect your true costs and value. This is a common strategy, with many small business owners resorting to measures like raising prices (47%) to stay afloat.
• Reduce direct costs: negotiate with suppliers or find more efficient production methods.
• Cut operating expenses: review overheads like rent, subscriptions, and utilities for savings.
• Increase sales volume: higher revenue can improve margins if your costs stay stable.

Learn more in how to increase profits.

With the right tools and knowledge, you can take control of your business finances.

Measure profitability with confidence

Knowing how to measure profitability gives you clearer insight into your business performance. Track your gross and net profit margins regularly, and use those numbers to guide pricing, cost management, and growth decisions.

Xero calculates your profitability automatically, so you can focus on running your business instead of crunching numbers. Get one month free and see your margins in real time.

FAQs on measuring profitability

Still have questions about measuring profitability? Here are answers to common concerns.

What's a healthy profit margin for a small business?

A healthy net profit margin typically ranges from 5% to 20%, depending on your industry. For example, some of the top profitable industries for small businesses by net margin include entertainment software (27.43%) and retail real estate investment trusts (REITs) (25.47%). Service businesses often have higher margins than retail or manufacturing due to lower direct costs.

How often should I measure profitability?

Review your profit margins monthly or quarterly to spot trends and respond to changes quickly. Measure more frequently during periods of rapid growth or cost fluctuations.

What profitability KPIs should I track?

Focus on gross profit margin and net profit margin as your core KPIs. These show how efficiently you convert revenue into profit at different stages of your cost structure.

What are the five main profitability ratios?

The five main profitability ratios are gross profit margin, operating profit margin, net profit margin, return on assets (ROA), and return on equity (ROE). For most small businesses, gross and net margins are the most practical to track.

What should I do if my profit margins are lower than expected?

Review your pricing, negotiate better terms with suppliers, reduce operating expenses, or look for ways to increase sales volume without proportionally raising costs.