What is Profit Margin And How To Calculate

Profit Margins

What is Profit Margin?

Profit margin is the percentage of revenue that includes profit and not business expenses. Also, the profit margin is the amount you earn on each sale of a product or service. Your business’s profitability is directly related to how well it is performing.

Understanding your profit margin is crucial when managing your company finances. Although it may seem obvious, small business owners often forget or don’t understand the importance of profit margins. This includes what their margin goals should actually be.

This guide will explain what profit margin is and how to use it to calculate your profit margin. Let’s get started.

Types Of Profit Margin

Small businesses can measure two types of profit margins:

Gross profit margin

The gross profit margin equation is used to calculate the profit margin for a product or service and not an entire organization. A business subtracts the labor and materials costs from the product’s retail price to determine its gross profit margin. The retail price is then divided by that. If you sell a product at $25 and it costs $20 to produce, your gross profit margin would be 20% ($5 divided by 25).

Net profit margin

This equation is used to calculate an entire company’s profit margin. Net profit margin is calculated when the company’s net income for a period is divided by the net sales. Let’s take, for example, a company that generates a $200,000 net income and net sales of $600,000. Divide those numbers by 100 to get a profit margin of 33%.

Net profit includes all business expenses into account, not just the cost of goods. The net profit margin is a measure of how efficiently your business converts profits from sales. While the gross profit margin determines whether a product or service is profitable.

Profit Margin Formula

The net income divided by net sales is the profit margin formula. The following formula is used by most businesses to calculate the profit margin for a business:

Profit Margin = (Net Income/Net Sales) x 100

You will subtract revenue from the cost of goods sold to calculate gross profit. To calculate gross profit, you can use the following formula:

Gross Profit Margin = Revenue – Cost of Goods sold / Revenue x 100

A strong gross profit margin is an indicator that your business generates more profit than your expenses.

Also read: Top 10 Financial Calculator Apps

How to Calculate Profit Margin

We now have an understanding of the net profit margin and gross profit margin formulas. Let’s get into the details of each component.

Net Income: Net Income is the total of all revenue and expenses. Net income also includes expenses like debt payments, taxes, investments, and general administrative expenses.
Net Sales: Gross sales are gross sales minus any discounts, returns, or allowances. To accurately predict revenue, businesses use net sales.
Revenue: Revenue refers to the sales of your company’s products or services. It doesn’t include operating expenses.
Cost of Goods sold: Your cost of goods is the total cost to produce the goods or services you offer. This usually includes labor and materials.

You need to examine all details to be able to accurately assess your small business’ profit margin. You should keep track of everything, from expenses such as payroll and utilities to revenue sources like transaction fees or maintenance agreements. This will give you a clear picture of your company’s margins. However, you need to be careful not to make any mistakes or take anything out of the books.

Example of Profit Margin

This example shows how to calculate profit margins.

Let’s suppose you own an e-commerce company, ABC E-commerce. ABC E-commerce had $800,000. In 2019, that’s an annual revenue of $800,000. Your net income was $250,000. Your cost of goods was $300,000.

To calculate your profit margin, First, calculate your net income and sale income. Once you have identified your net income, net sales, and profit margin formula, you can apply it.

Here’s how you can calculate ABC E-commerce’s profit margin.

ABC E-commerce Profit Margin = (250,000/$800,000.00) x 100 = 31.25

You will need revenue and COGS to calculate ABC E-commerce’s gross profits.

ABC Ecommerce’s Gross Profit Margin = (800,000-300,000)/ $800,000.000 x 100 = 62.55%

ABC ECommerce’s profit margin of 31.25% and gross profit margin of 62.5% are the highlights.

Why Profit Margin is Important

There are some slight differences in the definition. A profit margin is the percentage of revenue after deducting all costs, taxes, and depreciation. Interests and other expenses are usually included.

These are just a few reasons to monitor your profit margins.

  • It helps to grow your business: Calculating your margins can help determine excessive spending and underperforming products or practices for your company. This data is useful to have in your arsenal when you evaluate how your business grows and expands.
  • It allows you to flag and resolve problems: Keeping track of your margins will help you identify any issues that may be affecting your business. If your profit margin is low you could be experiencing pricing errors, poor expense management, or accounting problems.
  • This is required for financing: A compelling product, idea, or service products and services your business offers. However, lenders will want to see your financial statements before they offer you a small-business loan. Even if you’re already making millions, It’s harder to get financing if your lenders don’t know if you are profitable.

You can calculate your profit margin to see how much revenue is actually going to your bottom line as opposed to covering your business expenses. This important metric can help you determine if your product is priced too high or low.

What is a Good Profit Margin?

A good profit margin very much depends on your industry and expansion goals, as well as a host of other factors like the economy. Sometimes it can seem like you are comparing apples and oranges.

Industries that have low overhead costs like consulting can make higher profits than restaurants, which pay overhead costs for facilities, payroll, inventory, etc. S&P 500 reported a blended net profit margin of 11.6% for Q1 2018. Margins of more than 11% are better than those of the market. However, a margin below 15% to 20% is indicative that there are risks to market fluctuations. It’s difficult to compare all small businesses against this average, as each business is unique and operates differently.

Below are some factors that influence what constitutes a “good” profit margin.

  • Industry specifics: NYU conducted a study of profit margin data across various industries. This is a great starting point for understanding average profit margins in your industry. It is very variable: Advertising has a net profit margin of 6.04% while the alcohol industry has an average margin of 19.13%. Computer services can expect to make 6.02% profit while agriculture/farming hovers at 3.18%.

To get a better idea of the potential opportunities, do some research in your industry and your local area. A financial consultant can provide sound advice about where your business should go.

  • Expansion goals: Imagine if you compared your business’s revenue to your expenses and found that you have a comfortable profit margin of 7% and are happy with your business. You don’t feel the need for expansion. That’s great! It doesn’t take much to make a profit and your margins are sufficient to support you in any economic crisis or natural disaster.

However, if you are hungry for more, your margins may need to be higher in order to achieve your expansion goals. This could include buying new equipment or increasing your credit line.

  • Longevity and size: A brand-new business will likely have higher profit margins Because overhead costs like payroll are less. However, as you grow, this number will likely decrease percentage-wise. But that doesn’t mean that you’re making less. According to AEI, Walmart has a profit margin of around 3%. Bottom line: If your income rises, it’s OK if your profit margin falls. It’s important to keep track of this.

INDUSTRY NAME = NET MARGIN

  • Auto and truck = 6.35%
  • Construction supplies = 3.99%
  • Furniture/home furnishings = 6.02%
  • Hotel/gaming = 8.06%
  • Information services = 12.94%
  • Real estate development = 17.33%
  • Retail (Online) = 2.97%

Also read: How Account Management is the Key to Business Success

How can you Improve Your Profit Margin?

Understanding your margins and knowing what a good profit margin is is the first step to improving your margins. These are just some of the ways that you can improve your business’ profit margin once you have this data.

  • Reduce expenses: Understanding your profit margin will help you identify excessive spending habits and help you make informed decisions about how to reduce costs. This is all about keeping overhead low while still producing a high-quality business product.
  • Reduce underperforming products and services: This principle is the same. Maybe your gross profit margin analysis shows that one of your products is manufactured at a higher cost, but isn’t selling as well as other products on the market. This decision is yours, but it is one way to increase your profit margin percentage.
  • Expand product offerings and services: Can your business do more with the same overhead costs? This will result in more money in your pockets. You might consider going the extra mile with the resources you have. If you don’t need large financial investments to achieve this, it may be worth it. To get more from your loyal customers, you can increase the product offerings and/or services they receive.
  • Increase pricing: While it can be difficult for small businesses competing against larger companies to raise prices, sometimes it is necessary for the long-term survival of your business. You want to make sure that your prices are not too high, but also ensure that you don’t undercut yourself by offering very low prices.

Bottom Line

It can be difficult to determine profit margins and understand what is right for your company. Research your industry to determine the best way to track your numbers down to every revenue source and expenditure. It’s important to know where your profit margin is. This information can help you decide where to go next.

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