Let’s make an example. You are running a firm providing professional services. Your average revenue per project is 10.000 EUR. One potential client calls you and asks you if it is possible to do a project for 8.000 EUR. Should you reject or should you accept the offer? In order to answer this question, you need to calculate marginal revenue and marginal profit margin.
In the following paragraphs, we will discuss different types of revenue and profit margins and explain how you can make decisions like the one mentioned in the previous paragraph.
Types of revenue
There are three ways you can calculate revenue:
- Total revenue (revenue in absolute amounts)
- Average revenue
- Marginal revenue
In the following paragraphs, we will present formulas for each type of revenue.
Total revenue formula
The first category you see in your income statement is total sales (total revenue or revenue in absolute amounts).
Total revenue is calculated using the following formula:
Abbreviations:
- TR – Total revenue
- ASP – Average selling price
- Q – Total quantity of goods/services sold
An example from the first paragraph, if you do 60 projects in a year, and average selling price for project is 10.000 EUR, the total revenue is 600.000 EUR.
When analyzing your business, you do not have to look only at the absolute amount of total revenue, but also at the relative (%) changes of total revenue (year over year, quarter over quarter, month over month, planned vs. realized, etc.).
Average revenue formula
As you may understand from the previous formula, average revenue (average selling price) is calculated using the following formula:
You do not have only to calculate the average revenue per production unit (product unit, service unit, project, etc.). In a similar manner, it is also possible to calculate average revenue per client, per hour, per service line, per employee, etc.
Marginal revenue formula
Marginal revenue is calculated using the following formula:
Abbreviations:
- MR – Marginal revenue
- ∆TR – Change in total revenue
- ∆Q – Change in sold quantity
As it can be seen from this formula, marginal revenue is an increase of revenue per additional sold unit. In other words, it is the average selling price for additional product units only. If your potential client asks you to perform 2 new projects for 17.000 EUR then your marginal revenue is 8.500 EUR per project.
In a similar manner, it is also possible to calculate marginal revenue for new clients, employees, service lines,s, etc.
Most common types of profits – total, average and marginal profit
Since the goal of each business is to maximize profit, not to maximize revenue, in order to make a decision whether you should accept the project or not, you need to look if accepting these projects will increase your profit or not. Therefore, in the following paragraphs we are going to provide information on basic types of profits and profit margins.
As we divided revenue in categories of total revenue, average revenue and marginal revenue, we can divide profits in a similar manner:
- Total profit
- Average profit
- Marginal profit
Total profit is calculated using this formula:
Abbreviations:
- TP – Total profit
- TR – Total revenue
- TC – Total costs
Namely, total profit is a simple difference between total revenue and total costs in absolute amounts. If your total revenue is 600.000 EUR and total costs is 500.000 EUR, total profit is 100.000 EUR.
Average profit is calculated using this formula:
Abbreviations:
- AP – Average profit
- TP – Total profit
- Q – sold quantity
Namely, average profit is the total profit per sold product unit. If you make a total profit of 100.000 EUR with 100 projects, you make an average profit of 1.000 EUR. In a similar manner, you may calculate the average profit per client, per project, per service line, etc.
Marginal profit is calculated using this formula:
Abbreviations:
- MP – Marginal profit
- ∆TP – Change in total profit
- ∆Q – Change in sold quantity
As it can be seen from this formula, marginal profit is an increase of profit per additional sold unit. In other words, it is the average profit for additional product units only. If your new 2 projects bring you 4.000 EUR of profit, marginal profit is 2.000 EUR.
Most common types of profits – income statement positions
In the income statement (profit & loss statement) you can identify different types of profit, on the basis of which costs are included in the calculation of profit:
- Gross profit
- EBITDA (Earnings before interest, taxes, depreciation and amortization)
- EBIT (Earnings before interest and taxes)
- Net profit
We have provided the profit margin calculator down below.
Most common types of profit margins
For each of the previous profit categories, you can calculate profit margins. The way to calculate profit margins is presented in the following paragraphs.
How to calculate profit margin
Generally, the profit margin is calculated in the following manner:
Abbreviations:
- PM – Profit margin
- PF – profit category you chose to calculate margin for
- TR – Total revenue
Please note that if you are calculating margin profit per unit, you should divide profit per unit with price (revenue) per unit.
Profit margin calculator
An example of an income statement (profit & loss account) along with profit margins is presented in the following picture:
Sales subtracted by costs of goods sold equals gross profit.
EBITDA (Earnings before interest, taxes, depreciation, and amortization) equals gross profit subtracted by all operating expenses (costs of salaries, overhead expenses, sales expenses, etc.) except depreciation and amortization costs.
EBIT (Earnings before interest and taxes) or operating income equals EBITDA less depreciation and amortization costs.
Net income is EBIT less other expenses (non-recurring expenses), financial expenses, and corporate income tax.
Profit margins for each of these profit categories is calculated by dividing profit by total revenue.
Marginal profit calculator
In the end, let’s solve the problem from the beginning.
A potential client has offered you to finish the project for 8.000 EUR, while the estimated costs of the project are 7.000 EUR:
If you achieve marginal profit, you should accept the project. Otherwise, it is not rational to accept the project.
The calculation of marginal profit is presented in the following table:
Since accepting a project leads to a higher gross profit of 1.000 EUR, you should accept the project.
Please note that we calculated marginal profit as incremental gross profit since we assumed that additional project leads solely to increase in costs of goods sold, while other costs remain the same. In reality, other costs could increase because of accepting the additional projects.
Download Excel model with the calculation of profit margins
We offer you both previously described calculators for free download.
Founders of TimeAnalytics have previously created successful tax and financial advisory firms. We had challenged (various organizational and financial challenges), which we solved with Time Analytics software, time tracking software specialized for professional service firms. The software is a technology platform that solves various management issues faced by most professional service firms.
We are business doctors, prescribing the medicine we take ourselves.
Bojan Radojičić
Bojan Radojicic, Master Degree in Economics, is a financial performance consultant with more than 15 years of experience. He is responsible for adding value services based on innovative solutions.
