In order to grow your business, you need to measure performance. One strong indicator of success is determined by calculating the profit margin.
What is profit margin?
Profit margin is a metric you can use to see how much money your business is making. It measures how well you use earnings to pay for outgoing expenses. In other words, the profit margin determines what percentage of revenue your business keeps. Calculate profit margin to see profitability during a specific time period.
You can use profit margin to track your business’s health and make better business decisions. Profit margin can also provide information for investors comparing companies with similar revenue.
Sometimes, profit margin is confused with net profit, but there is a difference between profit and profit margin. To find your profits, subtract all the expenses from earnings. Profit shows the dollar amount your business keeps after costs, not the percentage.
Gross and net profit margins
There are two ways to look at profit margins: gross and net. Each type of margin shows profitability differently.
Use gross margins to look at the profitability of a single product or service. You can see the amount of revenue from each item you keep. That way, you know which items are the most and least profitable.
Gross profit margin does not help you measure your business’s overall profitability. To know how profitable your company is, you must look at net profit margin. The net profit margin compares your total earnings to expenses. Most of the time, net profit margin is what people talk about to determine profitability.
How to calculate profit margin
The profit margin formula is simple and helps you keep your finances on track.
There are three steps to calculating profit margin:
- Determine the net income (subtract the total expenses from the revenue).
- Divide the net income by the revenue.
- Multiply the result by 100 to arrive at a percentage.
Profit margin example
To get a better understanding of profit margin, let’s walk through the process. Keep the above steps in mind while figuring out how to determine profit margin.
Bob’s Bakery is looking for business capital to expand the business. Potential investors want to know if the business is making money. They also want to know how well the business uses its incoming money. Use the bakery’s income statement to determine its profitability.
Step 1: Determine the net income.
Find net income by subtracting the total expenses from revenue. If the total expenses are $75,000 (cost of goods sold and operating costs) and the revenue is $100,000, the net income is $25,000.
$100,000 Revenue – $75,000 Expenses = $25,000 Net Income
Step 2: Divide the net income by the revenue.
Using the net income found in step 1, calculate net income divided by revenue. In other words, divide $25,000 by $100,000 to get 0.25.
$25,000 Net Income / $100,000 Revenue = 0.25
Step 3: Multiply the result by 100.
To make the result a percentage, multiply by 100.
0.25 X 100 = 25%
The profit margin is 25%. Bob’s Bakery keeps 25% of its earnings after covering expenses.
What are standard margins?
As a small business owner, you know that no two companies are the same. Knowing the average profit margin for small business can be difficult.
The average net profit margin depends on a lot of different factors. Consider the type of business you run, the number of employees you have, and business location. Operating systems, use of business assets, and inventory management also impact profit margin.
You can’t compare your profit margin to companies operating in other industries. Each industry has its own averages. The following are common industries and their average profit margins:
- Retail clothing: 7% to 12%
- Telecommunications: 10% to 15%
- Equipment manufacturing: 6% to 10%
- Electronics stores: 5% to 8%
Compare yourself to small businesses, not all businesses in the industry. Most small businesses have less than $2 million in annual sales and fewer than 20 employees.
How to improve profit margin
For a higher profit margin, you might need to make some changes. You need to lower costs and increase sales to improve profit margin.
To lower your costs:
- Cut offerings that don’t sell. These items take up space and do not convert into dollars.
- Change vendors. Shop around to see if you can get a better deal from a different vendor.
- Reduce waste. Don’t buy unnecessary items, and reduce business expenses by looking for alternative solutions to current processes, like creating a paperless office.
To raise your sales:
- Discount old inventory. Get rid of old inventory by selling items for less.
- Increase your prices. If you’ve used the same pricing strategy since day one, it might be time to increase prices to match your experience.
- Improve customer retention. Acquisition can be costly. Engage on social media and use cross-selling strategies to retain current customers.
Profit margin can help you see the results of your business decisions. Use this small business metric to measure your company’s progress and health.
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