Your business’s profitability plays a major role in whether your company succeeds or fails. And if you want to find out how profitable your business is, you need to look at your profit margin.
But if you really want to see where your business stands, you have to do a little more digging and analyzing. So, how can you do that? The answer is simple: complete a profit margin analysis.
What is a profit margin analysis?
Before you can jump into a profit margin analysis, you need to know what profit margin is.
Profit margin is a metric you can use to see how much money your business is making. Your small business profit margin measures how well you use earnings for business expenses. Investors might also look at your profit margin ratio to see how well your business is able to manage expenses and generate profits over time.
You can calculate profit margin to determine your business’s profitability during a specific period of time.
If you want to calculate profit margin, follow these three steps:
- Find net income (Gross Income – Expenses)
- Divide net income by your revenue
- Multiply the result by 100
A company’s average profit margin depends on many factors, including the type of business, number of employees, location, use of assets, and inventory management.
Each industry has its own average for profit margin. A low profit margin for one industry might be considered high for another. For example, the average profit margin for one industry might be 10% while another industry’s average is 7%.
When you begin to analyze your profit margin, be sure to compare your business to other small businesses in your industry.
Profit margin analysis
Now that you’ve brushed up on all things profit margin, it’s time to dive deeper into profit margin analysis. So, what is a profit margin analysis?
A profit margin analysis is pretty straightforward. With a profit margin analysis, you analyze your business’s profitability over time. Some businesses might complete an analysis to compare themselves to their competition. You can also compare your company’s profit margin to other businesses in your industry to see where you stand.
Generally, you perform a profit margin analysis over a longer period of time (e.g., five years). However, some businesses look at longer or shorter periods of time when analyzing their profit margin.
Types of profit margins
There are three main profit margin percentages that you should be aware of. These include:
- Gross profit margin
- Operating profit margin
- Net profit margin
If you want to gain insight into your business’s profitability, learn how to calculate the three different percentages. Then, compare your findings to your competitors’ percentages.
Gross profit margin analysis
Gross profit margin tells you how much profit your business makes on its cost of goods sold (COGS). Your margin can also indicate how efficiently you use labor and supplies in your production process.
Use the formula below to find gross profit margin for your business:
Gross Profit Margin = (Sales – COGS) / Sales
Things like changes in sales prices, number of products sold, and your product mix can impact your gross profit margin.
Operating profit margin analysis
Your operating profit margin compares earnings before interest and taxes (EBIT) to your sales. You can use your operating profit margin to see how well your business generates income from your business operations.
To calculate the operating profit margin, divide your EBIT by gross sales.
Operating Profit Margin = EBIT / Sales
Net profit margin analysis
Your net profit margin compares net income and sales. To calculate net profit margin, use the formula below.
Net Profit Margin = Net Profit / Sales
Conducting a profit margin analysis
If you want to do a profit margin analysis for your business, there are a few steps you need to follow. Use the three steps below to conduct a profit margin analysis for your business.
1. Calculate your gross, operating, and net profit margins
Using the formulas from above, calculate your gross, operating, and net profit margins for any specific time period.
2. Research competitors’ margins
Research your competitors and other small businesses in the same industry. When researching competitors’ profit margins, make sure you’re able to answer the following questions about each competitor:
- What is their gross profit margin?
- How much is their operating profit margin?
- What is Company XYZ’s net profit margin?
- Have their margins changed over time? (e.g., increased or decreased)
3. Compare results
After you gather information about you and your competitors’ profit margins, you can begin comparing your results.
Ask yourself questions like, How does my profit margin differ from my competitors’? Have their margins improved over time? How can I improve my margin using my research?
Continue to track and analyze you and your competitors’ profit margins. You can use your findings to improve your profit margin in the future. For example, say your competitor’s profit margin took a plunge a few years ago. You can pinpoint what your competitor’s mistakes were and avoid doing them yourself.
Why should you conduct a profit margin analysis?
Conducting a profit margin analysis can help you grow your business as well as show investors why your business is worth it.
There are countless advantages to conducting a profit margin analysis. Your profit margin analysis can:
- Help guide you while making pricing decisions
- Identify weak areas in your business
- Show you what your competitors are doing right and wrong
- Catch red flags and resolve issues early on
- Show you where your profit margin falls in the industry
- Give you an idea of where you need to improve
- Help project profit margin in the future
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This article is updated from its original publication date of August 29, 2019.This is not intended as legal advice; for more information, please click here.