Businesses need to make money to keep afloat, and monitoring your profit margins helps you know the health of your business and tells you if your company can grow.
Whether you're a well-established business or a startup working out of a garage, you should understand your profit margins. Here's what you need to know about profit margins, according to the business owners and finance experts we spoke with.
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What is a profit margin?
Profit margin is the measure of a business's profitability. Profit margin is expressed as a percentage and it measures how much of every dollar in sale that a business keeps from its earnings. Profit margin represents the company's net income when it's divided by the net sales or revenue. Net income or net profit is determined by subtracting the company's expenses from its total revenue.
How do you calculate profit margin?
Let's start with your gross profit margin. This is the simplest metric for determining profitability and one of the most widely used financial ratios. Suppose your business makes $100 in revenue, and it costs $10 to make your product. If you make more than one thing, you can either average the costs of making each product or calculate a separate gross margin for each product.
The cost of making a product is known as the cost of goods sold, or COGS. It includes wages and raw materials, but not things such as overhead and taxes. In this example, revenue minus the cost of goods sold would be $100 - $10 = $90. Once you determine your gross profit ($90), divide that number by your revenue ($100): $90/$100 = 0.9. To get the final percentage, just multiply that number by 100, which makes the profit margin 90% in this case.
Why is profit margin important?
Your profit margin shows how much money your business is making, the general health of your business and problems within your business.
"Profit margin is important because, simply put, it shows how much of every revenue dollar is flowing to the bottom line," said Ken Wentworth of Wentworth Financial Partners. "It can quickly help determine pricing problems. Further, pricing errors can create cash flow challenges and, therefore, threaten the ongoing existence of your entity."
Glenn Gutek, CEO of Awake Consulting and Coaching, agreed. "Your profit margin reveals the general health of the business," he said. "Your profit margins tell you the return on investment (ROI) for all your expenses. When your margin is low, you are not getting the best ROI for the expenses of the business."
What is a good profit margin?
Knowing your industry is key. "For example, in the restaurant industry, margins are typically less than 10%," Wentworth said. "However, in the consulting world, margins can be 80% of more – oftentimes, exceeding 100 to 300%."
Business owners should create an annual budget for their company in order to set their own profit margins based on their own set of assumptions. Then, find out what your industry's standard profit margins are. Then compare and contrast the two.
What are the different types of profit margin?
Gross profit margin (mentioned above) is the simplest profit margin to calculate. To get a better feel for how much of your revenue you have left, use calculations for operating profit margin and net profit margin. The gross profit margin is your overall gross revenue minus the cost of goods. It may not reflect other major expenses.
Operating profit margin accounts for operating costs, administrative costs and sales expenses. It includes amortization rates and asset depreciation, but it does not include taxes, debts and other nonoperational or executive-level costs. It tells you how much of each dollar is left after all the operating costs to run the business are considered. Here is the formula for operating profit margin: operating profit margin = operating income/revenue x 100.
Net profit margin is the most difficult type of profit margin to track, but it gives you the most insight into your bottom line. It takes into account all expenses, as well as income from sources such as investments. Here is the simplified formula for net profit margin: net profit margin = net income/revenue x 100.
Your net income also can be defined as your gross revenue minus pretty much all of your costs, including COGS, operating expenses, interest, taxes and other expenses.
[Related Article: Knowing the Difference Between Net Income and Gross Income]
How can you improve profit margins?
As a business owner, you should always know how your business is spending money. One of the most important steps in improving your profit margins is tracking expenses. If you don't know what you're spending money on, how can you cut costs and ultimately improve your profit margins?
If your gross profit margin and operating profit margin are healthy but your net profit margin shows issues with the bottom line, you have nonessential operating costs and overhead to cut. If the problem shows up at the level of the operating profit margin, your operating costs are more than you can cover at the price you're charging for goods or services.
[Related Read: What Is a Profit and Loss (P&L) Statement?]
If your calculations show problems, you should pay attention to unnecessary expenses, such as subscriptions and extra office perks, such as coffee for the office, said Deborah Sweeney, CEO of MyCorporation.com. Cut these costs first if you're having cash flow problems.
"Buy in volume during times when cash flow is less of an issue, and try to stock up during strong seasonal times," Sweeney said. "Determine what you spend versus what can be cut out; the more detailed you can be, the better."
Wentworth recommended tracking specific customer and product profit margins. If you have an unprofitable product or service, you should raise prices, reduce production costs or discontinue it, he said.