Like every small business owner, you’re always seeking new ways to improve profitability. One way to do this is to focus on increasing your profit margin. But what is profit margin, and how do you calculate it?
We’ll answer those questions and also give you some tips on how you can improve your business’s profit margin.
What is profit margin?
As a rule of thumb, profitable businesses are the ones that make more money than they spend. For this reason, your profit margin is one of the most important metrics to track for your business.
In simple terms, profit margin is the percentage of each dollar of revenue that your business retains as profit. The higher the percentage, the more profitable the business. That’s why your profit margin is the most essential financial ratio for monitoring the health of your business.
How is profit margin calculated?
There are actually three types of profit margins you can use to evaluate your financial performance: gross, operating, and net profit margins. Here’s a closer look at how each is derived.
Gross profit margin
Gross profit margin is the easiest to calculate. Here’s the equation:
Your revenue is the total income generated by your business before subtracting any expenses. Cost of Goods Sold, or COGS, is the total cost required to make or acquire any goods sold during the reporting period. COGS include direct costs like raw materials, labor wages, and factory overhead expenses.
For example, if you sell products for $6,000, and it costs you $2,000 to produce them, your gross profit would be $4,000. The gross profit margin is then calculated as ($4,000/$6,000) x 100 or 66%.
Your gross profit margin can show if you are overspending on COGS for your product or service, which results in a lower profit margin.
Operating profit margin
Operating profit margin is a bit more comprehensive and, therefore, more complex. It takes into account not only the Cost of Goods Sold but also all other operating expenses (OPEX), such as marketing, rent, and payroll.
An operating profit margin measures a company’s ability to turn its revenue into profits after deducting the costs of doing business. The higher the operating profit margin is, the more profitable a company is. Operational profit margin can be considered a more precise measure of profitability because it includes all operating costs associated with running the business, while gross profit margin only accounts for the Cost of Goods Sold.
To calculate the operating profit margin, take the revenue and subtract the Cost of Goods Sold and all operating expenses. Then, divide that number (also known as operating income) by total revenue and multiply by 100. The equation looks like this:
For this example, we’ll use our $6,000 of revenue from above with $2,000 in operating expenses and $1,000 in Cost of Goods Sold. The total operating income would be $6,000 - $2,000 - $1,000 = $3,000.
Then we’d just apply the operating profit margin formula, which would be $3,000 / $6,000 x 100, which equals 50%.
Net profit margin
You can calculate your net profit margin using your net income, also known as “the bottom line,” because it’s found on the last line of your income statement. Net income takes into account all expenses, including both operating and non-operating expenses. Non-operating expenses include things like interest on loans, taxes, and depreciation.
Net profit margin can tell us a lot about a company, including how efficiently it’s run and how much pricing power it has. It can also give us an idea of how much money a company could pay out as dividends. Generally, the higher the net profit margin, the better a company is doing.
The net profit margin formula looks like this:
To calculate the net profit margin, take the operating profit and subtract all other expenses. For example, if your revenue is $30,000 and all of your other expenses (COGS, OPEX, interest, taxes) total $20,000. Your net profit or net income would be ($30,000 - $20,000)=$10,000.
Next, you divide net income by total revenue to get the net profit margin:
With a net profit profit margin above 30%, your business is incredibly efficient at generating sales while keeping all expenses low. Nicely done!
- How to Calculate Profit Margin and Markup (Formula and Examples)
- How to Calculate Net Income (Formula and Examples)
Good, standard, and high profit margins
What exactly are good, standard, and high business profit margins? This is a question that many new business owners struggle with. In fact, not all profit margins are created equal. A good margin for one business may not be sufficient for another. In some cases, a high profit margin may be necessary to stay afloat, while in others, an average profit margin can still be profitable.
Net profit margins vary by industry but according to the Corporate Finance Institute, 20% is considered good, 10% average or standard, and 5% is considered low or poor.
Good profit margins allow companies to cover their costs and generate a return on their investment. A healthy profit margin is important for the company’s long-term success as it allows them to reinvest in the business, expand, and hire more employees. A high profit margin can also make a business attractive to prospective investors.
However, once a business reaches a low or poor profit margin, it won’t be able to cover production costs and will suffer losses on sales. Businesses with high costs or ones with low sales can experience low profit margins.
Profit margins by industry
Since the definition of a “good” profit margin varies so widely across industries, a bit of additional context might help.
The information below, taken from NYU’s table of profit margins by sector, shows the average gross and net profit margins of 22 different industries for 2022.
|Industry||Gross Margin||Net Margin|
Industries with the highest and lowest profit margins
As you can see, average profit margins can differ widely by industry, and the difference between gross and net margin is sometimes drastic.
The high gross margins of businesses such as system and application software and information service companies are generally the result of lower operating costs. These industries carry little to no inventory, making them easier and relatively inexpensive startup businesses. Companies that sell products with higher price tags, like telecom equipment and precious metals, also tend to have high profit margins.
Grocery stores and food wholesalers, on the other hand, are often seen as low-margin ventures. They have high expenses due to the need for inventory, corporate employees, and labor workers in order to sell goods at a profit.
Additional factors such as the business’s age, size, and location can affect profit margin. Newer businesses typically have higher profit margins since they haven’t yet hired many employees or required larger rental space, which decreases their overhead expenses.
The geographic location of your business can also impact your profit margins. Real estate in San Francisco, California, is considerably higher than that in Atlanta, Georgia, which can greatly impact your office or store rental costs.
How to increase your profit margin
The best way to improve your profit margins is by focusing on pricing strategies and reducing overhead costs. Improving these numbers can lead to higher profits at year-end, which can open the door for growth in other areas of the business.
Many business owners are hesitant to raise their prices because they fear they will lose customers to the competition. However, if your business is growing and demand continues to rise, higher prices may be necessary to maintain your market share.
This is another obvious way to improve your margin. If you can find ways to reduce your expenses, such as using more inexpensive suppliers or cutting back on non-essential expenses, then you’ll be able to increase your margin.
You can also lower expenses such as insurance, equipment repair, shipping, and business software by negotiating lower rates or downgrading existing services.
Carefully choosing what to sell to avoid high shipping costs can also make a difference. For example, if you sell delicate or bulky items such as big-screen TVs or furniture, your shipping costs will cut into your profit margins.
This is a less obvious way to improve your margin, but it’s just as effective. If you can find ways to increase your sales, then you’ll be able to realize a larger profit while keeping your business expenses the same, which will increase your margin.
Focus on high-margin products
One of the best ways to improve your profit margins is by focusing on high-margin products and eliminating those that aren’t profitable. Researching these types of products in your industry can help you select the most appropriate ones for your business. However, be sure to avoid big markups on your products, as that can backfire by scaring customers away.
Retain customers with loyalty programs
Loyal customers are worth their weight in gold. In fact, it costs businesses five to 25 times more to attract new customers than retaining existing ones.
Customer loyalty programs that reward loyal clients for their repeat business can reduce your advertising expenses since they help retain your customers, resulting in an increase in total sales.
How Bench can help
Bench, the nation’s largest professional bookkeeping service, has you covered on all of your business accounting and financial needs. Our team of experienced experts will prepare monthly financial statements that do the calculations for you, so you can stay on top of your business’s financial health without agonizing over the numbers. Bookkeeping works better with Bench.
Why is it important to know your small business’s profit margins?
The various profit margins in your business should be a key factor for you to consider when making decisions about which products and services will generate the most money and understanding how different costs influence your cash flow and net profit.
There is no single answer when it comes to good profit margins, but by understanding your profit margins, you have a clearer picture of your business’s financial health and where you may need to make adjustments.
Ready to dig a little further into your income statement? Check out these resources: