Small businesses are always looking for ways to increase revenue. Whether by increasing sales, eliminating redundancies or decreasing internal expenses, organizations are on the lookout for the next big cost-saving measure that will free up valuable cash flow.
What many small businesses may never calculate, however, is their business’ profit margin, an essential figure for anyone trying to find ways to increase the bottom line. A company’s profit margin is the easiest and quickest way to tell how efficiently a company uses its resources, and it’s a great tool to gauge a company’s profitability.
What Is a Profit Margin?
Profit margin is defined as a ratio of profits earned to total costs over a defined period (e.g. a quarter, a year, etc.). Each industry generally has its own average profit margin due to the differences in costs and materials needed for different products and services.
There are two types of profit margin that small businesses might find useful:
- Gross Profit Margin: The gross profit margin equation is typically used to determine the profit margin of a singular product or service, not of an organization as a whole. To determine the gross profit margin, a business looks at the retail price of its product and subtracts the cost of materials and labor used to produce it. It then divides that by the retail price. For example, if you sell a product for $25, and it costs $20 to make, the gross profit margin is 20% ($5 divided by $25).
- Net Profit Margin: This is often the equation used to determine an entire organization’s profit margin. Net profit margin is calculated by taking the company’s total sales for a given time period, subtracting total expenses and then dividing that figure by total revenue. For example, let’s say your company generates $10 million in sales and has operating expenses of $5 million. The net profit margin would be 50% ($10 million – $5 million = $5 million; $5 million divided by $10 million equals 50%).
While it’s useful to know your business’ gross profit margin, we’re going to focus our attention on net profit margin and its uses for business.
When Is Net Profit Margin Used?
Net profit margin is used by businesses that are looking for ways to boost their revenue, want to evaluate a product or service or simply want to take an inventory of what they’re spending versus what they’re making.
For example, a company may offer three different product types and find that, although overall company sales are steady, one product’s sales have seen a decline in recent months. After figuring out the net profit margin for that particular produce line, the company might decide that it’s within its best interest to discontinue the product.
Another example might be an organization that has been feeling the financial pinch over the past six months. If there isn’t a clear-cut answer as to why (i.e. a competitor has entered the marketplace, or external economic conditions are bad), it might be best to conduct a profit-margin analysis. Oftentimes, net profit margin uncovers a large expense or group of expenses that are torpedoing the company’s profits. It could also reveal that market demand can support a price increase.
What’s the Catch?
The catch is the time and effort it takes to gather and verify all costs. To get an accurate net profit margin, a company must include every expense as part of the total. This includes things like payroll, utilities, inventory, administrative costs, shipping, etc. Every line item in your ledger that accounts for money being paid to someone else must factor into your total expenses line item.
Similarly, all revenue sources must be gathered as well. Don’t forget non-traditional revenue sources, such as transaction fees or maintenance contracts. Chances are that you and your financial team will have a much clearer picture of your revenue streams than you do your expenses, so be careful and avoid miscalculations when calculating each amount.
Let’s say you’ve gathered all of your costs, triple-checked every line item, input your total revenue and generated your net profit margin. Here are a few options of what to do with it:
- Nothing: It’s quite possible your net profit margin is outstanding, so there’s no immediate need to tweak numbers to improve it. Congratulations on running an efficient and profitable business!
- Explore the option of increasing product offerings or setting higher sales goals: If your profit margin is good, this might be the perfect time to explore growth opportunities. How would your profit margin be affected if you attempted to increased sales by 20%? How much would your costs increase? Could you maintain the same profit margin, or would there be a decline?
- Talk to decision makers in your organization, and make a plan: If your profit margin leaves something to be desired, it’s probably time to make a change. Speak with the decision makers in your company—especially the ones that hold the purse strings—and examine ways to increase profit by decreasing expenses. Things like renegotiating contracts, shifting production schedules or hiring new employees all have an effect on your revenue and expenses. Try a few different permutations until you get the end result you want.
In all instances, it’s a good idea to take a long look at any sweeping changes that might result from tweaking your net profit margin. For example, although a particular product might not be as profitable as it once was, what are the ramifications of doing away with it entirely? To make sure you’re not throwing the baby out with the bathwater, consider your customers, your employees and your company’s brand when making any kind of change.
Net profit margins are also a great benchmark figure to take a look at every year, whether you feel the need to analyze your costs or not. For many finance-minded business owners, it’s a better measure of a company’s profitability since it takes expenses into account, not just sales. It’s possible for a company to have millions of dollars in sales yet still not be profitable.
A good profit margin is a great indicator that your company is doing well. For more indicators, see our article on the seven signs that show your company has good financial health.