Businesses need to make money to keep afloat. Tracking and monitoring your profit margins is important, because it indicates the health of your business, and 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 and determine what they should be. Business News Daily talked to business owners and finance experts – here's what you need to know about profit margins.
What is a profit margin?
Profit margin is the measure of profitability for a business. "Profit margins are measured in percentages, and it measures how much out of every dollar of a sales a business keeps in earnings," said Linda Herron, CEO of SimpliProfit.
"It is the company's net income divided by the net sales (revenue)," Herron told Business News Daily. "Net income or net profit is also determined by subtracting all the company's expenses from its total revenue."
For example, suppose your business makes $100 in revenue, and it costs $10 to make it ($100 - $10 = $90). Once you determine your gross profit, divide that number by your revenue margin ($100). $90/$100=0.9. Next, multiply that number by 100, which makes the profit margin 90 percent.
Why is it important?
Your profit margins are important, because it shows how much money your business is making, the general health of your business, plus it can identify 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, agrees. "Your profit margin reveals the general health of the business," he told Business News Daily. "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 should your profit margins be?
Your profit margin really depends on your industry. "For example, in the restaurant industry, margins are typically less than 10 percent. However, in the consulting world, margins can be 80 percent of more – oftentimes exceeding 100 to 300 percent," Wentworth told Business News Daily.
Herron recommends that all business owners create an annual budget for their company. "This will allow them to set their own profit margins based on a set of assumptions. Then I would find out what your industry standard profit margins are and compare them."
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?
Deborah Sweeney, CEO of MyCorporation.com, recommends paying attention to unnecessary expenses like subscriptions, coffee for the office, and extra office perks, and cut them when 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 told Business News Daily. "Determine what you spend versus what can be cut out – the more detailed you can be, the better."
Wentworth recommends tracking specific customer and product profit margins. If you have an unprofitable product, raise prices, reduce production costs or discontinue the product or service. You can create more profitable customers by deepening the relationship into more profitable products or increasing prices.