More money is good money, right? In most cases, yes, but small business owners must also take into account another, slightly more complicated metric: the profit margin. In other words, what percentage of your revenue comes out as a profit against all your business costs and expenses?
While it seems logical, there are many things small business owners either don’t know or forget about profit margins—including what your profit margin goals should be to begin with. In fact, according a 2013 Reason-Rupe poll, most people believe that business profit margins hover around 36%—which is about 5X too high! See our helpful guide to assess good profit margin goals for your small business below.
Why do you need to know your profit margins?
Of course, it’s good practice to have a thorough, accurate understanding of your business’s financials, but these are a couple of other reasons you should track your profit margins:
- It helps you grow your business: Figuring out your profit margins can help you determine excess spending or underperforming products and practices for your business. It’s helpful data to have on hand when evaluating how your business moves forward as it grows and expands.
- It’s required for financing: You might have a very compelling product, idea, or service that your business offers, but lenders are going to want to know where your profit margin stands. Even if you’re already making millions, if lenders don’t know whether you’re not profitable, it’s more difficult to secure financing.
What do you calculate?
It depends on what you’re trying to measure. According to the QuickBooks Resource Center, there are two types of profit margins that small businesses can measure:
- Gross profit margin: The gross profit margin equation is typically used to determine the profit margin of a single 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%).
How do you calculate?
In short: tedium. You need to keep track of everything: from expenses like payroll, utilities, and shipping to every source of revenue, including the small stuff like transaction fees or maintenance contracts. This gives you a very clear picture of your company’s profit margins, so you have to be extra careful not to miscalculate or leave anything off the books. OmniCalculator is a great online tool for helping you determine profit margins.
What’s a “good” profit margin?
It very much depends on your industry and expansion goals and a host of other factors like the economy, etc. It can sometimes seem like comparing apples to oranges. Industries with hardly any overhead costs, like consulting, for example, have higher profit margins than, say, a restaurant, which pays overhead costs in facilities, payroll, inventory, and so on. According to a Yahoo! Finance report, average profit margins across 212 industries hovered around 7.5% in 2015, which is not saying that’s a good or bad relative number—it really depends.
See some factors that affect what makes a “good” profit margin below:
- Industry specifics: NYU ran a study on profit margin data in various industries, which is a great jumping off point in terms of understanding the average profit margins for your industry. It varies greatly: While advertising has a net margin of 6.04%, the alcohol industry has a net margin of 19.13%. Similarly, computer services can expect to make 6.02% profit, while farming/agriculture hovers around 3.18%.
Make sure to do the research on your industry—and in your geographic area—to get an idea of what you may be able to expect. You can also speak with a financial advisor to get sound advice on where your business should be.
- Expansion goals: What if once you calculate your business revenue against you’re expenses, you find that you’re at a comfortable profit margin (say 7%) and you’re happy with where your business is and don’t feel the need to expand? That’s great! You don’t need to do anything and your profit margin should be able to sustain you, barring any drastic circumstances such as an economic crash or environmental disaster in your area of business.
But if you’re hungry for more, your profit margin might need to be higher to reach some of your expansion goals, whether that means buying new equipment or increasing a line of credit. According to Investopedia, profit margins under 15%-20% indicate vulnerability to negative market changes and might make it difficult for a company to fund substantial growth. But really, it’s up to you.
- Longevity and size: A brand new business is likely have higher profit margins, because the overhead costs such as payroll are likely lower. As you expand, however, that number is very likely to dwindle, percentage-wise, though that doesn’t necessarily mean you’re making less money. For example, according to AEI, a big corporation like Wal-Mart only has a profit margin of around 3%. Bottom line: It’s OK if your profit margin decreases as your income increases. Just make sure to keep track of it thoroughly.
More example industry profit margins from the NYU study:
How can you improve your profit margin?
Of course, knowing your profit margin is the first step in improving your profit margin. Once you have that data, these are just a few ways you can help your business improve its profit margin:
- Decrease expenses: Knowing your profit margin can help uncover bloated spending practices or help you make decisions about where to cut costs. It’s all about keeping your overhead as low as possible, while still being able to produce a quality business product.
- Cut underperforming products or services: Same here. Perhaps your gross profit margin analysis determines that one of your products is manufactured at a higher cost, but isn’t selling as well as other products on the market. Making that call is only yours to make, but it’s certainly one way to bring up your profit margin percentage if that is indeed the goal.
- Increase product offerings or services: Could your business be doing more while maintaining equivalent overhead expenses? If so, this means more money in your pocket. Consider going the extra mile with what you already have, and if you don’t need to make huge financial investments in order to accomplish that, then it might be time to just go for it.
Profit margins can be tricky—both determining them and understanding what’s right for your business. Do your research for your industry and make sure to track, track, track those numbers down to every last expenditure and revenue source. Knowing where you are with your profit margin helps you determine where to go next, and it’s different for every business.
Looking to start a business fresh? See Fundera’s list of the Top Five Most Profitable Industries for Small Business Owners in 2017.
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from Fundera Ledger https://www.fundera.com/blog/profit-margins