Most people who own a company would say that a big reason they’re in business is to make money. There’s more to being successful, however, than the absolute dollar amount you bring in.
Revenue and profit are important, but alone they do not provide the full picture of a company’s overall health. Revenue shows how much you’ve earned and profits show how much money your company has made in absolute terms. Margin ratios, however, offer a look at your profitability by telling you how much you’re making relative to your revenue. It’s not an absolute metric, and that’s a good thing.
“Many small business owners lose sight of the bottom line by just focusing on top-line revenue growth,” says David Rudofsky of Rudofsky Associates, a business planning, cost management and profitability consultant. “Many owners don’t take the opportunity to improve profit margins by also managing cost of goods sold and pricing.”
Maintaining or improving profit margins allows you to reinvest in your company by hiring people, increasing marketing, improving technology, moving into a larger space, paying down debt or paying a dividend to investors. Companies with good margins also have more money for working capital. Conversely, falling margins are an early warning sign that something may be wrong, which can lead to budget cuts or downsizing. Importantly, if you’re looking for outside financing, margins are a key metric that funders use to determine whether or not they will invest in your business.
Calculate Gross and Operating Margins
Profit margin is the ratio—or percentage—of profit to sales. Using a percentage allows you to compare your profitability to industry standards. This same metric also allows you to compare product or market segments within your company.
Small businesses should track both gross and operating margins. Individually, each ratio shows how well the company is using its resources to generate profit. Together, these ratios offer a general view of how profitable your company is.
Your gross margin tells you the profit your company is making after accounting for the cost of goods sold (COGS). It indicates how efficiently you are using labor and supplies in the production process. To calculate your company’s gross margin, it’s as simple as subtracting your COGS from your revenue.
Your operating margin takes into account costs that are unrelated to the direct production of the product or service, such as overhead and administrative expenses.
Operating margin is an even better indicator of your company’s health than gross margin. You can have a large gross margin but a small operating margin because you are spending money on research and development or expanding to new locations. To calculate your company’s operating margin, subtract your company’s overhead costs—including any depreciation and amortization—from your gross revenue.
High and increasing operating margins allow you to invest in expansion and growth. Low and decreasing operating margins may lead to downsizing or budget cuts.
Compare Yourself to the Competition
Knowing how you stack up to the competition signals how well you are doing and whether or not you should adjust how you do things. Slim margins may be the norm in some industries such as supermarkets, while high margins are typical for industries such as software. Individual company margins will vary within an industry, but you can expect a predictable range. “Businesses are well advised to find out what the norm is for their business,” says Rudofsky.
RMA’s Annual Statement Studies is a good source of comparative industry data. Many public libraries provide free access to these reports.
Low margins compared to your competition can indicate any of several issues, including not enough sales to cover expenses, incorrect pricing or paying too much for supplies. “The analysis is an opportunity to discover the root causes of the problem,” according to Rudofsky.
Use Product Margins to Point to Challenges and Opportunities
As useful as they are, looking at margins on a company-wide level won’t tell you the entire story. You may need to apply these margin formulas at more focused levels of the company. Doing so will help you avoid overlooking small-yet-critical problems, and may even help you reveal opportunities.
There are many ways to segment and analyze your overall numbers. You can calculate margins for each product or product line, salesperson, territory, factory, warehouse or any other metric that will pinpoint differences. As long as you’ve paired revenue and COGS to whatever you’re tracking (e.g. product, salesperson, territory, factory, warehouse, etc.), calculating these numbers is relatively straightforward. To track operating costs, you can assign a number based on the percentage of sales that each product (i.e. as sold by salesperson, territory, etc.) represents of overall sales for the company.
To improve the profitability of low-margin products or business segments, you might cut costs, raise prices or even drop the product or service. For strategic reasons, however, you might keep a low-margin product as a loss leader. Hamburgers are a low-margin product for McDonald’s, but they’re a must-have on the menu. For high-margin products, you might expand into new territories or add new products to your lineup.
Make Reviewing Profit Margins a Monthly Practice
Few small businesses go through this necessary exercise. “A well-run business looks at their numbers on a monthly basis,” says Rudofsky. “If your numbers are one or two percentage points different over time, that’s not significant. It’s when the numbers are different by five percentage points or more that something significant is happening.” Analyzing margins is a great diagnostic tool for monitoring the health of your business.
Knowing what generates the biggest profit margins helps you determine where you should focus your resources for future growth and where you should cut costs or raise prices. It’s key to successfully growing your business, and thus deserves your regular attention.