This Is Why It’s Crucial to Know Your Business’s Profit Margin
What is a profit margin?
“Profit margin” is an expression of a business’s profit relative to its revenue. It’s a financial ratio that provides a more nuanced look at the profitability of a business than simply stating the revenue, because it takes into consideration factors like the cost of the goods that were sold and the business’s operational costs.
Why is it important to a business?
It’s not only useful to know your profit margins as part of being a well-informed business owner. You will also need it for two practical reasons.
First, they can be used strategically. You should know your profit margin so you can determine what areas need improvement. You can also use your net margin to compare to the average of your industry, and if it’s higher, it is considered a competitive advantage.
Also, if you require small business loans, lenders will want to know this number — just the revenue alone doesn’t give enough of the picture. The higher a business’s profit margin, the more prepared it is to withstand unexpected downturns.
How to calculate a profit margin
A company’s profits are calculated in three metrics:
- Gross profit margin: total revenue minus cost of goods sold (COGS). The result is then divided by the total revenue and multiplied by 100 to get the percentage. This metric is used to measure the profit of a single product or service, not that of the entire business, so that the business owner can use that information to see which products and services are more and less profitable. It is the simplest calculation because it does not take into account any other company expenses. It only shows the revenue minus cost of production.
- Operating profit margin, also called Earnings Before Interest and Tax (EBIT): revenue minus COGS and operating expenses. The result is then divided by the total revenue and multiplied by 100 to get the percentage. This one is more complex than the gross profit margin, this calculates what remains from each dollar once the company pays all other expenses to maintain the business. It’s often used as a measure of how similar companies across an industry stack up to each other. It also shows how well a company is managed because it focuses on variable expenses like rent, equipment and payroll, rather than fixed costs.
- Net profit margin: revenue minus all expenses, including interest and taxes. The result is then divided by the total revenue and multiplied by 100 to get the percentage. Or to put it more simply: it’s net profit divided by revenue. The most complex calculation, this one gives the bottom line by not just subtracting cost of goods sold and operational expenses, but any payments for debts, single-occurence expenses, plus any income from other ventures or investments.
When an acquirer is interested in buying another company, they would look at the operating profit margin to see how it compares to its competitors, not at the net profit margin. Here’s why: the leveraged buyout would mean new debt, so the former interest arrangement wouldn’t matter.
The way to ensure an accurate profit margin is to be sure to include all transactions, even the minute ones.
What’s a good profit margin?
The answer to this question varies wildly depending on the industry, but as very general guidelines, 5% or less is low, 10% is average and 20% is high.
A report by Sageworks of the most profitable industries in 2017 included, with the highest at 18.4%, accounting, tax preparation and payroll services, with lessors of real estate (17.9%), management companies and enterprises (16%), activities related to real estate (14.9%) and offices of real estate agents and brokers (14.3%), also faring well. The other theme at the higher end of profit margins is medical industries: dentists (14.8%), other health practitioners (13%), medical and diagnostic labs (12.1%).
The least profitable industries in 2017 (also from the Sageworks report) included beer, wine and liquor wholesalers at 0.9%, grocery stores at 2.2%, agriculture at 2.3% and assisted living for the elderly at 2.6%. The retailers with low profit margins like liquor sellers and grocery stores rely on volume sales to stay in business.
Why such wide variance in the profit margins? It can depend on a variety of factors like whether the business has a high overhead, or if it has to maintain a large staff, or keep inventory, as well as factors like the economy.
Because of the wide range of averages in different sectors, the only companies that should be compared using net profit margins are those in the same industry that have similar business models.
A high net profit margin shows that a company is successful and can either control its costs or charge significantly higher for its goods or services than the total of its costs. It’s an indicator of:
- Efficient management
- Keeping costs down
- Successful pricing strategies
On the other end of the spectrum, a low net profit margin could mean:
- Inefficient management
- High expenses
- Unsuccessful pricing strategies
Also keep in mind that profit margins may be higher when companies are in the early stages, when some costs such as employee salaries are lower. But that’s okay — they aren’t huge anywhere. In no industry did the average profit margin go higher than 18.4% in 2017, and even Walmart operated at a 3% profit margin as of a few years back.
As might be indicated by that Walmart statistic, a low profit margin does not mean a failing business, and high profit margins do not necessarily indicate high cash flows.
How to improve your profit margin
It’s a safe generalization that most for-profit business have a goal of making more profit. Some possible methods for improving your profit margin are:
- Supercharge revenues. Increase revenue by raising prices or selling more products. However, raising prices could backfire by alienating existing customers or lowering sales, and increasing production could result in inventory sitting unsold, depreciating. If you can raise revenues while also decreasing expenses, that could yield the desired results.
- Cut out the fat. You can spot if your cost of goods or your overhead are cutting into your profits, and make appropriate changes. If you manufacture, you may choose to use less expensive materials, although this can backfire if the product quality goes down. Expansion is one way to decrease cost of production without compromising the quality of the product. Higher production levels are cheaper through economy of scale.
- Drop the dead weight. Look at those gross profit margins for your products and services and see if any of your offerings are not performing at a rate that justifies the cost to make them.
- Ask your experts. You have a built-in consumer focus group in your customers. Ask them how you can improve your products or services.
- Find untapped revenue. Look for new markets for your existing offerings.
- Expand on a budget. Look at the numbers and brainstorm opportunities to add to production without increasing overhead.
The bottom line
Knowing your profit margin is one of the ways to be a well informed business owner. With it, you can take the pulse of the financials, pinpoint problem areas or places to improve and be armed to make the best decisions for the business.