How to calculate profit for your business: formulas and a worked example

To calculate profit, you would take your total revenue and subtract your total costs. If the answer is above zero, your business has made a profit. If it's below zero, it has made a loss. That simple formula is a good starting point, but it helps to know how to calculate profit at three different levels: gross profit, operating profit and net profit. Each one takes off a different layer of costs, so together they show you where your money goes.

This guide covers the formula for each type of profit, a step by step worked example, how to turn profit into a margin, how profit is taxed for sole traders and limited companies, and practical ways to increase what you keep.

What is profit?

Profit is the money your business has left after paying all the costs of running it over a set period, usually a month, a quarter or a financial year. It's sometimes called earnings, or simply "the bottom line", because net profit sits on the last line of your profit and loss account. Profit isn't the same as revenue. Revenue (also called turnover or sales) is the total value of your sales before any costs come off. A business can have high revenue and still make very little profit if its costs are high, which is why profit is the better measure of whether your business is actually making money. Profit also isn't the same as the cash in your bank account, as the section on cash flow below explains.

What is the basic formula for profit?

The basic profit formula is:

Profit = total revenue minus total costs

For example, if your business brings in £120,000 in a year and spends £95,000 running it, your profit is £25,000. This tells you whether you made money overall, but not where your money went. Splitting your costs into groups and working out gross, operating and net profit shows you that.

What are the different types of profit?

There are three main types of profit, and each one takes away more of your costs than the one before it.

You'll find all three on your profit and loss account, also called an income statement. Accounting software will usually calculate them for you, but knowing how each figure is built helps you see where profit is being lost.

How do you calculate gross profit?

You calculate gross profit by subtracting your cost of sales from your revenue.

Gross profit = revenue minus cost of sales

Cost of sales, sometimes called cost of goods sold (COGS), covers the costs directly linked to making or delivering what you sell. If you stopped selling, most of these costs would stop too. Depending on your business, cost of sales usually includes:

• The cost of stock or raw materials you buy to sell or turn into products.

• The wages of staff who directly make your products or deliver your service.

• Packaging and delivery costs for orders sent to customers.

• Subcontractor costs for work carried out on specific customer jobs.

Gross profit tells you whether your pricing and buying are working. If your gross profit is low, you may be charging too little, paying too much for stock or materials, or both. Rent, office salaries and marketing don't come into it yet, because they're overheads rather than direct costs.

How do you calculate operating profit?

You calculate operating profit by subtracting your operating expenses from your gross profit.

Operating profit = gross profit minus operating expenses

Operating expenses, often called overheads, are the costs of running your business that don't change directly with each sale. They typically include:

• Rent, business rates and utilities for your premises.

• Salaries for staff who aren't directly involved in production, such as admin, sales and management.

• Marketing, advertising and website costs.

• Insurance, software subscriptions and professional fees such as your accountant.

• Depreciation, which spreads the cost of equipment, vehicles and other long term assets over the years you use them.

Operating profit is often used interchangeably with earnings before interest and tax (EBIT). It's a useful measure because it shows what your core business earns before borrowing costs and tax. A closely related measure, earnings before interest, tax, depreciation and amortisation (EBITDA), also adds back the cost of depreciation and amortisation. Our guide to what EBITDA is and how to calculate it explains when that version is more useful.

How do you calculate net profit?

You calculate net profit by subtracting interest and tax from your operating profit.

Net profit = operating profit minus interest minus tax

Interest covers what you pay on loans, overdrafts and other borrowing. Tax means corporation tax if you run a limited company. The figure before tax comes off is called profit before tax, and the figure after tax is net profit, also called profit after tax. Sole traders and partners pay tax personally rather than through the business, so for them net profit is usually the same as profit before tax. Net profit is the most complete measure, because every cost has been taken into account. It's the money you can reinvest in the business, keep as a buffer or, for a limited company, pay out to shareholders as dividends. Any net profit you keep in the business rather than paying out builds up over time as retained earnings on your balance sheet.

How do you calculate profit step by step?

The easiest way to see how the three types of profit fit together is to work through one business's figures. Here's a year of trading for a fictional UK limited company that sells and installs kitchen fittings.

Here's how each step works:

1. Start with revenue of £400,000 and take off the £240,000 cost of sales, which gives a gross profit of £160,000.

2. Take off £100,000 of overheads and £10,000 of depreciation, which gives an operating profit of £50,000.

3. Take off £5,000 of loan interest, which gives a profit before tax of £45,000.

4. Take off corporation tax of £8,550, which leaves a net profit of £36,450.

To keep the example simple, it assumes the company's taxable profit is the same as its accounting profit. In practice, your accountant will adjust the figure for tax purposes, for example by replacing depreciation with capital allowances, so the tax bill may be different.

How do you calculate profit margin?

You calculate profit margin by dividing your profit by your revenue and multiplying by 100. This turns a profit figure into a percentage, which makes it much easier to compare your performance over time or against similar businesses.

Profit margin = (profit ÷ revenue) × 100

You can work out a margin for each type of profit. Using the kitchen fittings example above:

• The gross profit margin is £160,000 ÷ £400,000 × 100, which is 40%.

• The operating profit margin is £50,000 ÷ £400,000 × 100, which is 12.5%.

• The net profit margin is £36,450 ÷ £400,000 × 100, which is roughly 9.1%.

In plain terms, this business keeps 40p of every £1 in sales after paying for materials and installers, 12.5p after paying its overheads, and around 9p after interest and tax. Watching how these margins change is often more revealing than looking at profit in pounds. If your revenue grows but your gross margin falls, your direct costs are likely rising faster than your prices, or you're discounting more. If your gross margin holds steady but your net margin shrinks, your overheads or borrowing costs are the likely cause.

What is the difference between profit margin and markup?

Profit margin and markup both use the same two numbers, but they measure profit against different things, which is why they're easy to mix up. Margin compares profit to the selling price, while markup compares profit to the cost.

Markup = (profit ÷ cost) × 100

Say you buy a product for £60 and sell it for £100, making £40 profit on each one:

• Your margin is £40 ÷ £100 × 100, which is 40%.

• Your markup is £40 ÷ £60 × 100, which is roughly 66.7%.

Mixing the two up is a common pricing mistake. If you want a 40% margin but add a 40% markup to your costs instead, you'll sell that £60 product for £84 and only make a margin of around 28.6%. Always check which one you're working with when you set prices.

What is a good profit margin?

A good profit margin depends heavily on your sector, your business model and the size of your business. A software company with low running costs will usually have much higher margins than a builders' merchant or a supermarket, where margins on each sale are thin and profit comes from high volumes. Rather than chasing a single target figure, it's more useful to compare your margins in three ways:

• Compare your margins with your own figures from previous months and years, so you can see whether they're improving or slipping.

• Compare your margins with businesses of a similar size in your sector, which your accountant or trade body may be able to help with.

• Compare your margins with your own goals, such as the profit you need to cover loan repayments, fund growth or pay yourself.

A falling margin is an early warning sign worth acting on, even if your overall profit in pounds still looks healthy.

How is profit calculated for tax?

The profit in your accounts isn't always the same as the profit you pay tax on. HM Revenue and Customs (HMRC) has its own rules about which costs you can deduct, so your taxable profit is usually worked out by adjusting your accounting profit. How it's taxed depends on how your business is set up.

Limited companies

Limited companies pay corporation tax on their taxable profits. According to HMRC's corporation tax rates, companies with profits of £50,000 or less pay the small profits rate of 19%, while companies with profits above £250,000 pay the main rate of 25%. Profits between those two figures pay the main rate but may be able to claim marginal relief, which means the effective rate rises gradually from 19% towards 25% as profits increase. These limits are reduced if your accounting period is shorter than 12 months or if your company has associated companies. Depreciation is one of the most common adjustments. It reduces the profit in your accounts, however HMRC's guidance says it's generally not an allowable expense for tax. It's added back to your profit, and you claim capital allowances on qualifying equipment, vehicles and machinery instead.

Sole traders and partnerships

Sole traders and partners pay income tax and National Insurance on their business profits rather than corporation tax. Your taxable profit is your income minus your allowable expenses. HMRC's guidance on allowable expenses gives a simple example: a business with £40,000 turnover and £10,000 of allowable expenses has a taxable profit of £30,000. The cash basis is now the standard way for sole traders and most partnerships to work out their profit, though you can choose traditional accounting instead. On the cash basis, you record income when the money arrives and expenses when you pay a bill, rather than when you send or receive an invoice. Limited companies can't use the cash basis. If your allowable expenses come to less than £1,000, you may be better off claiming the £1,000 tax free trading allowance instead, though you can't claim both. Tax rules change regularly, so check your figures with an accountant before you file a return.

Why can a profitable business still run short of cash?

A profitable business can still run short of cash because profit and cash flow are measured differently. In limited company accounts, a sale counts towards your profit as soon as you invoice it, but the cash only arrives when your customer pays. If you give customers 60 days to pay while paying your own suppliers in 30, you can be profitable on paper and still struggle to cover your wage bill this month. Some payments also affect cash without touching profit in the same way. Repaying the amount you borrowed on a loan, buying a new van outright or building up stock all take cash out of your bank account, but in your profit and loss account they either aren't a cost at all, or the cost is counted later or spread over several years. This is why it's worth tracking profit and cash side by side. Our guide to cash flow vs profit walks through a worked example of how the two can pull in opposite directions, and a regular cash flow forecast helps you spot a gap weeks before it becomes a problem.

What are the most common mistakes when calculating profit?

Most mistakes in calculating profit come from leaving costs out or putting them in the wrong place. The most common ones to watch for are:

• Leaving out the salary you pay yourself as a director of a limited company, which makes profit look higher than it really is. This doesn't apply to sole traders, because the money you take out of the business isn't a business expense.

• Mixing up revenue and profit when setting targets, so a record sales month is mistaken for a record profit month.

• Including value added tax (VAT) in your revenue figures if you're VAT registered, even though that money belongs to HMRC.

• Putting overheads into cost of sales, or the other way round, which makes your gross margin look better or worse than it is.

• Ignoring depreciation, so the cost of an expensive piece of equipment only shows up in the year you buy it and makes that year look much worse than the years after.

• Leaving out small recurring costs such as bank charges, card processing fees and software subscriptions, which add up over a year.

• Confusing margin and markup when setting prices, which can quietly cut your profit on every sale.

How can you increase your profit?

You can increase your profit by raising your revenue, cutting your costs or doing a bit of both.

• Review your prices regularly, since even a modest increase lifts your margin on every sale.

• Negotiate better terms with your suppliers, or compare suppliers, to bring down your cost of sales.

• Focus on your most profitable products, services or customers, and consider dropping the ones that barely break even.

• Encourage customers to spend more per visit or order, for example by bundling products or offering add ons.

• Cut overheads you no longer need, such as unused software subscriptions or underused space.

• Reduce the time customers take to pay you, so you rely less on overdrafts and pay less interest.

• Look at your borrowing, since refinancing with a lower rate or a better structure reduces the interest you pay and lifts your net profit.

Why do lenders look at your profit?

Lenders look at your profit because it shows whether your business can afford to repay what it borrows. When you apply for finance, a lender will usually ask for your latest accounts and look closely at your profit and loss account, paying attention not just to your profit in pounds but to how your margins have changed in recent years. A steady or growing profit suggests your business can cover new repayments comfortably, which can help you access larger amounts and better rates. A recent dip in profit doesn't automatically rule you out, but it helps to be able to explain why it happened and what you've done about it. Lenders will also look at your cash flow, your working capital and your credit history alongside your profit. When you're ready to borrow, you can apply for a business loan with Capitalise and compare offers from our panel of 130+ lenders.