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Ah, the good ol' profit margin. A term that every business owner knows all too well. Or maybe not. And if you're in that boat, you're in the right place.
Let us explain.
Understanding what a profit margin is, what's considered to be a good one, and how to calculate it are all core parts of the How to Run a Successful Business Without the Confusion Handbook. (Just kidding-that doesn't exist. But let us chat with our Marketing team about it.)
As a small business owner, a healthy profit margin is crucial to operating your business-no matter the industry you're in. That said, the industry does have a part to play in dictating what's good and what's not-so-good, but we'll go over that shortly.
Let's begin.
Profit margin shows the profitability of what you sell. Essentially, it's the percentage of revenue left over after every expense associated with a product or service has been deducted.
Profitable businesses make more than they spend. That's why your profit margin is such an important metric to track. The higher the percentage-i.e. the leftover amount-the higher your profit margin, and the more profitable your business.
Easy-peasy, right? Well, it will be-once you get a handle on the three types of profit margins.
This is the revenue leftover once the cost of goods sold (COGS) have been deducted. COGS refers to any and all costs that are needed to make what you're selling. Think of raw materials, labor costs, and overhead expenses.
This is the income that's left once you minus the COGS, plus operating expenses (OPEX). Operating expenses are made up of the costs that keep things running: rent, salaries, and payroll.
This is what's left after you deduct COGS, OPEX, as well as costs like interest and taxes. Net profit margin is a great indicator of your profitability. Essentially, it's the number at the end of your spreadsheet after all the calculations are done and the costs are subtracted. And to put some good vibes out into the business universe, picture that number in green. 💫
Now that you know the three types of profit margins, you can learn how to calculate them. And don't worry-you don't need to be a mathlete to figure it all out. (But if you are, that's cool, too. 😎)
Some may call this the simplest of the bunch. Here's how gross profit margin is calculated:
Gross profit margin = ((Revenue - Cost of Goods Sold) / Revenue) x 100
Your revenue is the total amount of money your business has generated before you've subtracted any expenses. COGS is how much it costs to make or get the goods you're selling.
Let's break it down. If you sell a bike for $3,000, and it costs you $2,000 to make it, your gross profit would be $1,000. The gross profit margin is then calculated as (($3,000 - $2,000) / $3,000) x 100 which would be 33.33%.
This percentage can help you understand if you're overspending on production, or sometimes, be an indicator that your prices need to be increased.
To begin, you'll need to know your operating profit. This can be calculated as such:
Operating profit = revenue - cost of goods sold - operating expenses
Now it's time to find the operating profit margin. Take the operating profit you've calculated above, divide it by your revenue then multiply it by 100.
Operating profit margin = (operating profit / revenue) x 100
Net profit margin: the number you're really after. To get it, you'll first need your net profit. You can use this formula to figure that out:
Net profit = revenue - cost of goods sold - operating expenses - interest - taxes
To get the margin, take your variables and use this formula:
Net profit margin = (net profit ÷ revenue) x 100
Tadaa! Magic. Or as some like to call it: math.
Remember when we talked about the number you want-the one you really, really want? Yup: that's net profit margin. And out of the three formulas we've provided, net profit margin is probably the most significant of the bunch when it comes to financial statements and tracking the health of your business.
That's because it accounts for everything: direct and indirect costs like rent, materials, marketing, labor costs, and even the time it takes for you to get the hang of Threads. (Time is money!)
But just because net profit margin is king, doesn't mean you should forget about the other calculations. For example, if you're looking to hone in on production costs, you'll want to focus on gross profit margin. This gives you insights into how efficiently you're managing the build or acquisition of your products and services, which can shed some light onto your pricing strategy.
According to this report by NYU, the average net profit margin in the US is approximately 7.71% across all industries.
But what does that really mean?
As a rule of thumb, a 5% net profit margin is considered low, whereas double that-10%- is considered a healthy profit margin. Double that you've got 20%, aka a high margin.
However, take this with a grain of salt. What makes a "good profit margin depends on the industry you're in.
Retail and SaaS, for instance, are two very distinct and very different businesses, so it's not unusual for one to have much lower margins on average than the other. For a Saas startup, there can be little overhead, but for an independent retailer, you've got product to purchase and maybe even a brick and mortar location and sales people to pay.
Plus, there's seasonality and economic events to consider.
Think of the Covid pandemic and a ride share's net profit margin versus an online retailer of sourdough starters. The net profit margins would be drastically different, just like the industries themselves.
Feeling a little less "keeping up with the Jones' but still want to make sure you're tracking in the right direction? We've got your competitive side-um, we mean research-covered.
Here's a list of industries and their average net profit margins sourced via NYU. When gathering info for comparison, look for your specific industry. And remember: there's no "one number that you should be looking for. Rather, keep the 5-10% rule in mind: anywhere in that range is considered okay.
How can you improve your profit margins? We thought you'd never ask.
There are a number of ways to do this, including raising revenue and/or cutting back on costs and expenses. You can also get a bit more creative and follow these tips for improvement:
This one might seem obvious, but for good reason: every single cost reduces your net profit margin. To stay organized and aware of where your money is going, keep receipts organized (outside of that old shoebox) and track every dollar including those of orders, manufacturing costs, payroll, and more.
When you track your income and expenses, you're able to understand where you can make cuts without making a negative impact. Maybe that means a smaller office space or a shop in a different (less expensive) neighborhood. Reducing operating costs can also include changing materials or suppliers, reassessing wages and benefits, tracking employee spending, or negotiating lower costs from service partners.
As a business owner, it can be hard to take a step back and let technology step in. But sometimes, it's necessary-especially when you want to increase net profit margins. For example, are there any parts of your business process that you can automate? Think of things like customer service emails: maybe you don't need to write and send every single one.
Speaking of customers, you can also explore software that collects their information, manages shipping notifications, and sends out communications afterward. Whenever you're not actively doing the work, you're saving money-and probably making more money with all those sales you can finally focus on.
Brand loyalty pays off. Literally. Consistently finding customers can be taxing, but when you focus on the customer experience and keeping your existing buyers happy, you can continue to make sales without the cost of lead generations and conversion.
Think of it this way: when you spend less on marketing for each sale, your profit margin goes up. Which means if you've been thinking about a reward program or a refer-a-friend promo, now might be a good time.
Knowing what makes you money (and how much) is a good first step to increasing your net profit margin. Once you know this, you can understand if a product or service is actually profitable. If it's not, consider reducing the amount you're selling and the marketing that's going into it. When you save on these costs, you can increase your profitability.
The beauty of owning your own business? You get to experiment. Explore different pricing methods and strategies to see what sells and what doesn't. This might mean value-based pricing (who doesn't love a good BOGO sale?), or boosting prices to find out how high the demand is of a certain product.
Good profit margins are something to strive for, especially since they're indicators of how your business is doing. It's a number that can show stability, profitability, and-if the numbers are good-can be a positive sign for lenders and investors.
Calculating your profit margin, whether it's gross, operating, or net, requires work outside of the equation. You need to track costs and expenses, and continuously monitor your finances.
But don't let that "F word intimidate you. Wave's accounting software makes tracking and staying on the pulse of your business simple, so you can focus on what matters: making money.
And figuring out Threads, of course.
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