Finance in focus: profit margins
For your business to survive long-term, you need to be generating a healthy and consistent profit. Your net profit margin is a key performance indicator. Here we explore the why, what, and how of profit margins.
Tracking financial data and measuring performance are essential to growing your business. One metric to keep a close eye on is your business’ profit margin.
Monitor your business’ financial health by comparing your profit to sales; this informs how well you’re managing your finances overall. With this insight, you can flag financial challenges quickly and make better-informed business decisions in the future. As an indicator of your business’ profit levels, a good profit margin can make your business more attractive if you’re seeking investment, for example.
What is profit margin?
Profit margin is a profitability ratio that measures the percentage of sales that turn into profit. By factoring in outgoing expenses, it denotes your true profit generated for each dollar of sale.
For example, if you achieve a 35% profit margin over a period, it means that you had a net income of $0.35 for each dollar of sales generated.
Types of profit margin
Small businesses often focus on three types of profit margins: net, gross, and operating.
Calculating profit margin
The basic profit margin formula takes the formula for profit (sales less total expenses), divides it by revenue and multiplies it by 100 to get the percentage value.
((sales – total expenses) ÷ revenue) x 100
Net profit margin
Net profit margin is the most common and is your company’s bottom line after all other expenses — including COGS, operational expenses, payments on debts, taxes, and one-off expenses — are deducted from revenue. It’s your business’ overall profit margin and is used to determine profitability and measure how much profit your business generates out of your total revenue.
The formula to calculate net profit margin is:
(Net income (revenue – COGS – operating expenses – other expenses – interest – taxes) ÷ revenue) x 100
If you provide professional services, you can use the cost of revenue rather than COGS.
Gross profit margin
Gross profit margin compares revenue to variable costs. It calculates how much profit a product or service generates without fixed costs (costs that vary based on the level of output).
While net profit margin is applied to your entire business, gross profit margin is generally used for a specific product or line. It’s a useful metric to determine the optimal pricing for products or services. For example, a low profit margin suggests you need to charge more to validate selling a specific product.
The formula to calculate gross profit margin is:
((total revenue – COGS/ cost of revenue) ÷ total revenue) x 100
Remember this calculation refers to a specific product, product line, or service, and the figures input should reflect this.
Operating profit margin
Your operating profit margin indicates how much profit your business makes after paying for variable costs of production. It factors in all day-to-day business overheads, and operating, administrative, and sales expenses — excluding debts, taxes, or other non-operational expenses. It’s an excellent way to see how efficiently you’re controlling the costs and expenses associated with operations.
The formula to calculate operating profit margin is:
(Operating income ÷ revenue) x 100
Ways to improve profit margin
While there’s no easy formula for calculating how to improve your profit margin, there are some adjustments you can make.
One simple step is lowering your costs. Consider if there’s room to reduce operating expenses; perhaps you can speak to your suppliers to get a better price or consider local vendors, or if you’re part of a business community or association consider collaborative procurement initiatives. Evaluate your current processes; is there room for greater efficiency? Do an audit of your products; can you cull underperforming products that don’t sell well, or suffer from a low gross profit margin?
Or take it from another angle: increase your sales! Streamline inventory with a sale on old or poorly performing items. Assess whether your products are optimally priced. Focus your marketing efforts. How can you increase visibility, attract new customers, and retain existing customers? Do you have an online offering, and is it driving the right traffic? Assess your sales funnel and consider upselling or cross-selling.
Your profit margin gauges how much money your business is making and is a clear indicator of the health of your operations. By assessing and managing your profit margin, you’ll flag any issues and identify how much of every revenue dollar is flowing to your capital.