Understanding profit margin is very important when you’re running a small business. By analysing this data, you’ll discover many changes you can make in your day-to-day operations that are likely to result in increased profit.
Your profit margin gives you an idea of the health of your company, tells you how much money your business makes, and lets you identify potential ways to improve your business.
Profit margin defined
Your profit margin is the amount of revenue left after paying for all the costs to deliver products or services. You can calculate this figure as a ratio of the net profit to the total revenue, and it provides a realistic idea of a business’s profitability.
If you strictly sell products, you can define product margin as the profit margin per product. If your company only offers services, you want to consider a wide range of factors, including the difference in hourly rates when you need to consult a senior employee versus an entry-level employee, direct and indirect costs, and marketing and administrative costs, to determine where you can cut costs.
Say company A has a total revenue of $100,000, and in order to make this amount of money, they have to spend $90,000. This means their profit is only $10,000. If company B’s total revenue is $50,000 and their total expense is just $10,000, it has a profit of $40,000. So despite having a lower revenue, company B is clearly more profitable than company A. But how much more profitable is company B?
The profit margin of company A in the previous example is $10,000 divided by $100,000, which is 10%. You can calculate company B’s profit margin by dividing $40,000 by $50,000, which gives you 80%. In other words, for each dollar of their revenue, company A makes a profit of $0.10 and company B makes a profit of $0.80.
What’s a high profit margin?
If you have a high profit margin, it means that you make a substantial amount of money on a product compared to its cost. Say you own a small software company that develops and sells technical software that customers pay top dollar for. If the cost to produce the software is relatively low, you probably have a high profit margin. Though there are exceptions, luxury retail stores typically have a high profit margin, whereas dollar shops have a low profit margin.
When you’re starting a business, it’s important to understand that its potential high profit margin doesn’t tell the whole story; you have to consider all the expenses to get a real sense of whether a seemingly high-profit-margin business idea will make money.
For example, jewellery is typically considered a high-profit-margin business, but if you’re opening a jewellery store at a shopping centre, your actual profit margin could be low if you have to pay a lot to rent space in the shopping centre and hire full-time employees.
Knowing whether a product has a high profit margin is a good place to start, but take expenses, such as production and marketing costs, into consideration as well.
What’s a low profit margin?
If you have a low profit margin, this means that the selling price you chose for a good isn’t much higher than its cost. If your company has a low profit margin, you’re likely in a very competitive industry and offering products that aren’t highly unique. But there are still many ways that you can increase your net profit. Consider focusing on making your company more efficient in terms of overhead spending to keep your net income positive.
If you’re running a company with a low profit margin, you should consider focusing on optimising processes and cutting the costs for supplies because there isn’t much revenue to cover any mistakes. A low profit margin may also indicate that there are some ways that you could alter your business to maximise productivity with minimum wasted expense or effort.
Say you run a clothing shop and have a great supplier providing you with low-cost fabric. If your competitor pays a premium for fabric, they’ll likely have a lower profit margin than your company will. Labour is another important factor that affects the profit margin. If it takes your competition twice as long to make a dress, they have to recoup twice as much labour expense.
In general, profit margins are lowest in industries involving food. For example, if you run a restaurant, you likely have low margins. The revenue you earn has to cover the costs of the food, meal preparation and service.
Retirement communities and assisted living locations have a low profit margin because of large overhead requirements. In addition, shops selling office supplies typically cannot charge higher margins because there’s a variety of similar goods available in the market.
Just because you may run a low-margin company doesn’t mean you necessarily need to make drastic changes. For example, Walmart is a low-margin company, but they make up for it with extremely high volume that gives them a huge net profit.
Use your profit margin to grow your business
Profit margin measures a business’s ability to turn each dollar of revenue into profit. One way to increase your business’s profit margin is to increase your revenue. You can do this by raising the prices of your products or services, but you don’t have to increase your prices across the board.
Instead, you can focus on raising the prices on your more popular or specialised products and services. Do you offer products or services that other businesses don’t sell? Consider bumping the price up a bit to try to increase your profit margin.
Another way you can improve your profit margin is to lower your discretionary spending, such as travel expenses. This may be a safer way to increase your profit margin because it usually doesn’t affect your customers directly. By monitoring and continually improving the profit margin of your business, you can make sure that it’s profitable in the long run.
Strategies for improving your profit margin
Whether you’re a lawyer, an accountant, the owner of a manufacturing company, or another type of professional, you likely pay office costs unless you’re working from home. That overhead can get expensive and cut into your profit margins. But don’t worry; there are many things you can do to boost and protect these margins.
To improve profit margins, you need to keep records. Consider using accounting software or another type of system to track profit margins. Even better, you can create reports on a regular basis that show your profit margin in various aspects of your business, so you can tell when there’s been growth.
Eliminate the office
A very effective way to boost the profit margin is to simply get rid of the office. The proliferation of mobile apps makes it possible to set up remote offices relatively easily. Giving your employees the option to work from home is likely to put a smile on their face, as they get to avoid traffic and work in a familiar environment. The happier your employees are, the better they’ll be able to work, which translates into higher profits for you.
There are apps that can track hours, facilitate meetings, generate financial records, organise group projects and keep everyone connected. If you need a space to meet clients, consider revamping a room in your home; in many cases, this also makes you eligible for the home office deduction, helping you keep more cash in your pocket. You can also consider working in a co-working space or shared office space.
For example, in some arrangements, you pay a monthly fee in exchange for use of a conference space, mailboxes and other office amenities. This gives you the benefits of having an office at a much lower rate than renting a full office.
If you can’t reasonably get rid of your office, you may want to consider using the space to generate extra cash. Do you have a cubicle that a telecommuter or independent contractor could rent? Do you want to rent your conference room to a startup on the weekends?
If you have a kitchen on-site, a small catering company may even want to rent it in the evenings or on weekends. Explore ideas to share your office space in ways that generate a bit of extra cash for your business.
Is your office still reliant on a lot of paper? If so, that’s another area where you may be able to lower costs. Although it only costs a few cents to print most office documents, it adds up over time, especially when you take into account the cost of printer cartridges and equipment maintenance. Consider getting rid of that aspect of your office and going paperless. It’s likely your team already has laptops, tablets or smartphones, and you can use those electronics for most paper-based tasks.
With the right programmes, you can share and modify documents, send invoices to clients and capture legally binding electronic signatures. Not only does this save you money, but it’s good for the environment, too.
Upselling and cross-selling
When you’re trying to improve your profit margins, cutting costs is a great start. You may want to also focus on increasing the amount of money coming through the door. Your existing clients are a great place to start.
They already patronise your business, and in most cases, it’s easier to convince them to buy more than it is to find new clients. Consider teaching your team to upsell and cross-sell your products and services.
Cut low-margin clients
Upselling and cross-selling help to improve the lifetime value of your customers, but you may still have clients who simply aren’t pulling their weight. Look through your list of clients and identify the ones with the lowest profit margins. In some cases, you may find that you’ve increased services for low-paying clients over the years without raising prices. When this happens, you often end up with clients with negative margins.
You can sit down with your clients and explain that you’ll have to raise costs to go forward. Some clients should be OK with the new pricing, but if they’re not, you may want to drop these clients.
If you typically pop expenses on a company credit card or use a line of credit to write payroll cheques, you’re spending money unnecessarily on interest payments. In this case, you may want to dive into some cash flow analysis to determine how much cash you’re likely to have on hand at any time so you can structure your bills and pay them in cash rather than with credit.
You may also want to look at ways to speed up your accounts receivable turnaround to boost the amount of cash you have on hand. If you can eliminate or reduce interest payments, your money becomes cheaper to use, which ultimately boosts your profit margin. Healthy profit margins can vary depending on the industry you’re in.
However, if you feel like your margin is too low, you may want to explore ways to increase it. Once you finish analysing and improving the profit margin in your office, you can start looking at other sectors of your business and improving the margins there.
Perform an annual profit and loss review
Consider performing an annual review of your business’s profit and loss (P&L) statement, also known as the income statement. Your P&L statement shows your revenue and expenses, with the difference being the net income or loss. As a small business owner, there’s often some temptation to skip this step or delegate this task to someone else.
However, examining your P&L at the end of the year is useful to check your progress against previously budgeted figures and compare to prior year numbers. You can use the P&L review process to create a more accurate budget for the next year. For instance, if expenses are running higher than planned, you can make adjustments, such as finding a cheaper source for products or optimising your workflow.
Analysing data is very helpful when you’re looking for ways to lower costs and find other ways to increase profit. Using an accounting system, such as QuickBooks Online, you can generate a profit and loss statement automatically. Learn how today.