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 to free up valuable cash flow.
What many small business owners may never calculate, however, is their business’s profit margin, an essential figure for anyone trying to find ways to increase their bottom line. A company’s profit margin is the easiest and quickest way to see how efficiently that company uses its resources, and it’s a great tool to gauge your company’s profitability. Best of all, it only requires a simple profit equation to figure out.
What’s the profit equation?
Much like a fingerprint, no two businesses are exactly the same. (Okay, fingerprints can be similar in extreme cases, but let’s pretend they can’t.) No two businesses will have the exact same expenses either. (Okay, some might have very similar expenses.) The good news is that the profit equation is fairly cut and dry, and only requires that you punch in some variables. The profit equation is as follows:
Profit = Gross Margin – Expenses
To further break this down, let’s look at each part of the equation. Don’t worry, there won’t be any long-form math problems, like way back in math class.
- Gross margin: Once you’ve taken out the cost of any supplies or materials, as well as any other variable costs or cost of goods sold, you’re left with your gross margin. Make sure not to mix up your gross margins with revenue, which is essentially the total amount you brought in based on the item’s selling price.
- Expenses: Any recurring fixed costs are expenses. Expenses typically include rent, salaries, phone bills, and so on.
With these definitions in mind, punch each item into the equation and solve to find your profit.
For example, let’s say your boot store has a yearly revenue of $100,000. Once you take out the cost of the leather and a new set of tools you had to buy, you’re left with $82,000. (This is your gross.) Next, you take out your expenses: the salary of your part-time cashier, the rent, taxes, and utilities. This comes out to $35,000. Now take the $82,000 and subtract the $35,000. This leaves you with a profit of $47,000. Not too shabby! (I guess this was kind of a long-form math problem. Sorry about that.)
Breaking down profit margins
Profit margin, often synonymous with net 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 the different products and services across different industries.
There are two types of profit margin calculations that small businesses might find useful.
1. Gross Profit Margin
As mentioned above, the gross margin is revenue minus variable costs. In the context of the 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.
Again, here 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 leather belt at your boot store for $25, and it costs $20 to make, the gross profit margin is 20% ($5 divided by $25). Note that it’s a margin percentage, not a dollar amount. This profit percentage can be handy if you want to know exactly what percentage of a sale goes back into your pocket.
2. 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 boot company has grown into a boot wholesaler that now 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, and $5 million divided by $10 million equals 50%). That’s a lot of boots!
While it’s useful to know your business’s gross profit margin, we’re going to focus our attention on net profit margin and its business uses.
When is net profit margin used?
Net profit margin is used by businesses that want to boost their revenue, evaluate a product or service, or take stock of what they’re spending versus what they’re making.
For example, your boot store may offer three different product types and find that, although overall company sales are steady, your bedazzled leather boot sales have seen a decline in recent months. (I wonder why?) After figuring out the net profit margin for that particular product line, you might decide to discontinue the product.
For another example, consider this: You’ve been feeling a financial pinch over the past six months. There isn’t a clear-cut answer as to why (i.e. a competitor hasn’t entered the marketplace, and external economic conditions aren’t bad), so 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 to determining profit?
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, you must gather all revenue sources 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 your expenses, but you should still be careful to avoid miscalculations for each amount.
What’s a good profit margin?
Now that you know how to calculate profit, you might be wondering what a good profit margin is. This isn’t quite as cut and dry as determining your profit margin, as there are numerous factors to consider. In order to figure out what a good profit margin is for your business, consider the following:
- Your industry: Not every industry has the same profit margins. For example, an accounting firm can have a profit margin near 20%, while a tech consulting firm may have one around 10%, with both businesses still being successful in their niche. Look at profit margins for your industry before you panic or celebrate.
- Age of your business: A newer business may have an inflated profit margin in some cases, on account of lower operating costs (smaller facility, less employees, and so on). Older businesses, on the other hand, can be more stable and have a lower but more realistic margin.
In short, there’s no single profit margin that’s “good.” Look at your business on its own, then compare yourself to others in your industry. Be sure to consider how established most businesses in your industry are before you jump to any conclusions.
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 for 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 increase 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 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.
Your (profit) equation for success
Net profit margins are 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 an indicator that your company is doing well. For more indicators, it’s one of the key signs that show your company has good financial health.