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When you sell a product or service, it’s important to understand your profit margin or how much money you make by selling your product. Essentially, a profit margin shows your return on investment (ROI) for all of your expenses. A low margin indicates you’re not getting the ideal ROI for your expenses while a high one proves you’re doing well.
Ideally, you’d have a high profit margin that steers your organization toward long term growth and success. By taking the time to figure out your profit margin, you can set attainable goals and make informed decisions for your unique business.
Profit Margin Formula
The profit margin formula is net income divided by net sales. Here’s a brief overview of what each of these figures means.
• Net sales: Gross sales minus discounts, returns, and allowances.
• Net income: Total revenue minus expenses.
Why Profit Margin is Important to Your Business
Profit margin is essential for your business because it can help you do the following:
• Grow your business: When you know what your profit margins are, you can easily pinpoint products that under-perform and you can reduce your expenses. Profit margins provide valuable data that can do wonders for your business as it grows.
• Identify and resolve problems: If you find that profit margins for certain products or services are low, you may uncover and take care of errors related to pricing, management, accounting, or something else.
• Obtain financing: To receive a small business loan for your business, you’ll need to show lenders what your profit margins are. Lenders want to know that your products and services have the potential to be profitable.
• Price appropriately: Your profit margins will show you how many of your dollars are contributing to your bottom line. This can help you figure out whether your offerings are priced too high or too low.
Profit Margin: How to Use the Profit Margin Formula
It’s easy to calculate your profit margin as long as you know how to use the formula. Let’s say your business sells vacuums. You find out that your net sales (gross sales minus discounts, returns, and allowances) level is $100,000. Your net income (total revenue minus expenses) is $300,000. If you divide $100,000 by $300,000 and multiply the number by 100, you get a profit margin of 33%.
Types of Profit Margins
There are a number of different profit margins you may want to calculate, including:
Gross Profit Margin
Total Revenue-COGS/Total Revenue X 100
The gross profit margin describes the income you receive after you deduct the cost of goods sold or COGS. Raw materials, labor wages, and any other expenses that are associated with producing or manufacturing your items are included in your COGS. Debt, overhead costs, taxes, and other expenses are not considered.
With the gross profit margin, you can compare how much gross profit you earned to your total revenue. The figure you come up with is a good reflection of the percentage of profit you retain after you pay to produce your products.
Operating Profit Margin
Operating Income/Net Sales Revenue X 100
Unlike the gross profit margin, the operating margin takes into account the overhead expenses that are required to operate a business. These may be things like operating, administrative, and sales expenses. While gross profit margin includes overhead expenses, taxes, debt, and other non-operational expenses are included.
The goal of the operating profit margin is to understand your revenue after you pay for producing your products and running your business. It can inform you about how well you can manage your expenses.
Net Profit Margin
Operating Profit-Interest Expenses-Tax Expenses/Revenue X 100
The net profit margin is a ratio that reveals residual income, which is the amount of money left over after you deduct non-operating expenses from the operating profit. These non-operating expenses may be debt expenses as well as one-time miscellaneous expenses. With this profit margin, you can understand how much of your revenue dollars translate into profit.
What is a Good Profit Margin?
A number of factors such as your specific industry, business size, growth goals, and the current economy will all dictate the definition of a good profit margin. If you work in an industry with minimal overhead costs such as childcare, for example, you’ll have higher profit margins than an event center that pays for facilities, inventory, and other costs.
Generally speaking, a 10% profit margin is considered average, while 20% is good and 5% is poor. To find a good profit margin for your business, do some industry research. Find out what’s the norm for similar businesses in your geographical area. You may also want to consult an accountant or financial advisor to get an accurate idea of where your profit margin should be.
How to Improve Profit Margin?
If you’re displeased with your profit margin, rest assured there are things you can do to improve it, such as:
• Cut expenses: Once you know your profit margin, you can make smart decisions on where to reduce costs. These costs may be things like fancy shopping bags, tissue paper, excess packaging, and overtime. Remember that your goal is to keep your overhead as low as possible while still providing your customers with quality products or services.
• Get rid of under-performing products and services: If you discover that a certain product or service isn’t selling well, you may want to remove it from your offerings. You can always replace it with something that’s more profitable.
• Raise prices: It can be difficult to increase prices, especially if you’re a small business competing with larger brands. If you’d like your business to thrive in the long run, however, it may be necessary. Undercutting yourself with low prices can inhibit success and growth.
• Elevate your brand: It’s no surprise that cosmetics brands have some of the highest profit margins. They use innovative marketing strategies to create emotional experiences with their customers and increase the perceived value of the products they sell. By elevating your brand, regardless of your industry, you can convince customers that your higher prices are worth it.
• Be strategic about discounts: In a perfect world, you wouldn’t offer any discounts. However, discounts are sometimes necessary to attract and retain customers. If you do offer discounts, be smart about them. Look at the purchase histories of your customers and design discounts that are tailored to their unique behavior and preferences. Not all customers will need a large discount or any discount to convert.
• Motivate your employees: No matter what type of business you’re running, it’s likely that your employees can do more to bring you higher profits. It’s your job to motivate them to do so by setting sales targets, training them on how to up-sell and cross-sell, and implementing bonuses and other incentives.
Can My Profit Margin Affect My Ability to Get Financing?
Chances are high that your business will need financing at some point to cover cash flow gaps or fund big purchases. In order to obtain it, you’ll need to show lenders that your business is in good financial health. You may do this by showing them your free business credit scores or business credit report.
Another way to demonstrate a positive financial situation is to provide them with a high profit margin. Once they compare your profit margin to those of your competitors, they’ll know how your business is doing financially. If your profit margin is high, lenders will view you as a responsible borrower that will likely repay your loan.
So, what does this mean for you? A favorable interest rate and terms that can potentially save you hundreds or even thousands of dollars down the road.
Monitor Your Profit Margin Frequently
Calculating your profit margin shouldn’t be a one time occurrence. Get into the habit of figuring out your profit margin on a monthly or quarterly basis. This way, you’ll know whether your profit margins are growing over time.
If they are, your organization is increasing sales faster than it’s increasing expenses and you’re on the right track. In the event they aren’t, you’ll need to make some changes and improve your efficiency.
About the Author: Anna Baluch is a freelance writer from Cleveland, OH who enjoys writing about all personal finance topics. She’s particularly interested in mortgages, retirement, insurance, and investing.
This article originally appeared on Nav.com.
Funded in part through a Cooperative Agreement with the U.S. Small Business Administration and a Grant with the Governor’s Office of Business and Economic Development. All opinions, conclusions, and/or recommendations expressed herein are those of the author(s) and do not necessarily reflect the views of the SBA or the Governor’s Office of Business and Economic Development. Reasonable accommodations for persons with disabilities will be made if requested at least two weeks in advance. Contact the California SBDC closest to you.