fbpx

Profit Margins: Definition, Formula, How to Calculate

When it comes to managing your business finances, understanding your profit margin is a crucial component. While it seems logical, there are many things small business owners either don’t know or forget about profit margins—including what their margin goals should be to begin with.

In this guide, we’ll define what profit margin is, as well as explain how to use the profit margin formula to calculate this number for your business. Let’s get started.

Types of Profit Margins

There are two types of profit margins that small businesses can measure:

  • Gross profit margin: The gross profit margin equation is typically used to determine the profit margin of a single product or service, not of an organization as a whole. To determine the gross profit margin, a business looks at the retail price of their product and subtracts the cost of materials and labor used to produce it. You’ll then divide that by the retail price. For example, if you sell a product for $25, and it costs $20 to make, the gross profit margin is 20% ($5 divided by $25).
  • Net profit marginThis is often the equation used to determine an entire organization’s profit margin: Net profit margin is calculated by taking the company’s net income for a given period and dividing by net sales. For example, let’s say your company generates $200,000 in net income and net sales of $600,000. Dividing those two numbers and multiplying by 100 gives you a profit margin of 33%.

Note that net profit takes all business expenses into account, not just the cost of goods. Your net profit margin helps you determine how efficient your business is at converting profits from sales, while your gross profit margin helps you figure out the profitability of a specific product or service.

Profit Margin Formula

The profit margin formula is net income divided by net sales.  To calculate the profit margin of a business, most organizations use the following formula:

Profit Margin = (Net Income/Net Sales) x 100

To calculate gross profit, you’ll need to subtract the cost of goods sold (COGS) from revenue. You can use the formula below to calculate gross profit:

Gross Profit = Revenue – Cost of Goods Sold

A strong gross profit margin means that your business is generating more profits over your costs.

How to Calculate Profit Margin

Now that you’re aware of the net profit and gross profit margin formulas, let’s go into further details about the formula components:

  • Net Income: Net income is the total revenue minus expenses. Net income includes business expenses such as debt payments, general administrative expenses, tax, investments, and more.
  • Net Sales: Net sales is gross sales minus discounts, returns, and allowances. Businesses use net sales to accurately predict revenue.
  • Revenue: Revenue is the total sales generated from your company’s goods or services. It does not include any of the operating expenses that go into your business.
  • Cost of Goods Sold: Your cost of goods sold is the total cost to produce your business’s goods or services. It typically includes materials and labor.

It’s important to remember that to get an accurate look at what your small business’s profit margin is, you need to look at all the details. Keep track of everything: from expenses like payroll, utilities, and shipping to every source of revenue, including the small stuff like transaction fees or maintenance contracts. This gives you a very clear picture of your company’s margins, so you have to be extra careful not to miscalculate or leave anything off the books. A great online tool to help you determine your margins is OmniCalculator.

The numbers that you need to calculate your profit margin will also show up on your latest profit and loss statement. If you need to update your income statement, you should be able to do so quickly with business accounting software.

Why Profit Margin Is Important

Although there are slight variations on the definition, a profit margin typically represents the percent of revenue earned after all costs, business taxes, depreciation, interests, and other expenses have been deducted.

These are some reasons you should track your profit margins:

  • It helps you grow your business: Figuring out your margins can help you determine excess spending or underperforming products and practices for your business. It’s helpful data to have on hand when evaluating how your business moves forward as it grows and expands.
  • It helps you flag and resolve issues: Staying in tune with what your margins are helps you identify issues you might be having running your business. For instance, if your profit margin is low, you might be having some pricing errors, expense management problems, or accounting issues.
  • It’s required for financing: You might have a very compelling product, idea, or service that your business offers, but lenders are going to want to know where your margins stand before offering you a small business loan. Even if you’re already making millions, if lenders don’t know whether you’re profitable, it’s more difficult to secure financing.

Once you have your profit margin, you can see how many revenue dollars are actually going to your bottom line, as opposed to covering your business expenses. This valuable metric can also reveal whether you’ve priced your product too high or too low.

What Is a Good Profit Margin?

A good profit margin very much depends on your industry and expansion goals and a host of other factors, like the economy. It can sometimes seem like comparing apples to oranges.

Industries with hardly any overhead costs, like consulting, for example, have higher profit margins than, say, a restaurant, which pays overhead costs in facilities, payroll, inventory, and so on. S&P 500 reports the blended net profit margin for Q1 2018 to be 11.6%.[2] Profit margins above 11% outperform those of the market, but a margin under 15% to 20% indicates vulnerability to negative market changes. Again, it’s hard to compare every small business against this average as all businesses are unique and operate differently. 

See some factors that affect what makes a “good” profit margin below:

  • Industry specifics: NYU ran a study on profit margin data in various industries, which is a great jumping-off point in terms of understanding the average profit margins for your industry.[3] It varies greatly: While advertising has a net margin of 6.04%, the alcohol industry has a net margin of 19.13%. Similarly, computer services can expect to make 6.02% profit, while farming/agriculture hovers around 3.18%.

    Make sure to do the research on your industry—and in your geographic area—to get an idea of what you might be able to expect. You can also speak with a financial advisor to get sound advice on where your business should be.
  • Expansion goals: What if once you calculate your business revenue against you’re expenses, you find that you’re at a comfortable profit margin (say 7%) and you’re happy with where your business is and don’t feel the need to expand? That’s great! You don’t need to do anything and your current margins should be able to sustain you, barring any drastic circumstances such as an economic crash or environmental disaster in your area of business.

    But if you’re hungry for more, your margins might need to be higher to reach some of your expansion goals, whether that means buying new equipment or increasing a line of credit. 
  • Longevity and size: A brand-new business is likely to have higher profit margins because the overhead costs such as payroll are likely lower. As you expand, however, that number is very likely to dwindle, percentage-wise, though that doesn’t necessarily mean you’re making less money. For example, according to AEI, a big corporation like Walmart only has a profit margin of around 3%.[4] Bottom line: It’s okay if your profit margin decreases as your income increases. Just make sure to keep track of it thoroughly.

More example industry margins from the NYU study:

profit-margins

How Can You Improve Your Profit Margin?

Of course, knowing what is a good profit margin and understanding your margins is the first step in improving your margins. Once you have that data, these are just a few ways you can help your business improve its profit margin:

  • Decrease expenses: Knowing your profit margin can help uncover bloated spending practices or help you make decisions about where to cut costs. It’s all about keeping your overhead as low as possible, while still being able to produce a quality business product.
  • Cut underperforming products or services: The same principle applies here. Perhaps your gross profit margin analysis determines that one of your products is manufactured at a higher cost, but isn’t selling as well as other products on the market. Making that call is only yours to make, but it’s certainly one way to bring up your profit margin percentage if that is indeed the goal.
  • Increase product offerings or services: Could your business be doing more while maintaining equivalent overhead expenses? If so, this means more money in your pocket. Consider going the extra mile with what you already have, and if you don’t need to make huge financial investments in order to accomplish that, then it might be time to just go for it. Remember, your best customer is often the customer you’ve already won, so consider increasing product offerings or level of services to your most loyal customers to get more out of them. 
  • Increase pricing: Raising prices can be a difficult decision for small businesses that are competing with larger companies, but sometimes it’s necessary for your business’s long-term survival. Make sure you’re not overcharging, but you also want to ensure that you’re not undercutting yourself with very low prices.

The Bottom Line

Profit margins can be tricky—both determining them and understanding what’s right for your business. Do your research for your industry and make sure to track those numbers down to every last expenditure and revenue source. Knowing where you are with your profit margin helps you determine where to go next, and it’s different for every business.

Article Sources:

  1. Quickbooks.intuit.com. “How to Calculate the Ideal Profit Margin for Your Small Business
  2. Factset.com. “S&P 500 Reporting Record-High Net Profit Margin for Q1 2018
  3. Stern.nyu.com. “Margins by Sector (US)
  4. AEI.org. “The public thinks the average company makes a 36% profit margin, which is about 5X too high

The post Profit Margins: Definition, Formula, How to Calculate appeared first on Fundera Ledger.

This post was originally published on this site

GET UP TO $500K IN BUSINESS FUNDING

Pin It on Pinterest

Share This
Xiphos Web Marketing

FREE
VIEW