How to Determine Profit margins? What is good?

profit margin

Tracking financial information is imperative for determining the growth of a business. Profit margin is one such metric that deserves special mention as it measures the company’s profits or earnings compared to its revenue. In easier words, a profit margin is the count of every dollar of sales that is retained by the company in its earnings. The cost of serving customers is also taken into account for determining the actual profit. Today we are going to discuss in-depth the determination of profit margin and means of improving the same.

What Is Profit Margin?

Before diving into the ways of determining profit margin, you need to have a clear idea of what it is exactly. It is the percentage of revenue retained by your business once the outgoing expenses have been met. Usually, the profit margin is calculated to check the profitability of a particular period. A 40% profit margin signifies that your business has generated a net income of $0.40 against each dollar of sales. Companies make it a point to calculate their profit margin for taking better business calls and understanding their company’s health. It also helps in finding quick resolutions to financial problems while making the business seem more attractive to investors. Now that you have developed a clear notion of profit margin, let us take a look at the different types of profit margins that investors, creditors, lenders, accountants, and business owners rely on:

  • Gross Profit Margin

Gross profit refers to the revenue left after taking the cost of goods sold (COGS) into account. COGS comprises all the related costs which go into the manufacture of your goods or services. Some examples of such costs are labor wages, raw material costs, and factory overhead expenses. The gross profit margin equation helps businesses in gauging the amount of revenue they can generate from each item. A business reporting robust sales might seem healthy but can become handicapped in the long run if the high operating expenses are not taken into account. Businesses can understand whether they are devoting excessive resources to a particular product or service from gross profit margin. This method is not of much help in calculating the entire businesses’ profit margin. Rather you can make out the most and least profitable items from computing their gross profit margins using the following formula:

Gross profit = Revenue – Cost of goods sold

Gross profit margin = (Gross profit ÷ Revenue) x 100

  • Operating Profit Margin 

Operating profit refers to the income after deducting operating expenses and the cost of goods sold. Operating expenses are incurred for maintaining the normal operation of your business. This comprises items like marketing, payroll, inventory software, etc. Taxes, interest payments, and other non-operational expenses are not included in calculating operating expenses. COGS is the direct cost incurred on creating the products and services. You can calculate operating profit by using the formula:

Operating profit = Revenue – Cost of goods sold – Operating expenses

Operating profit margin = (Operating profit ÷ Revenue) x 100

  • Net profit margin 

Businesses can gain an accurate picture of their performance through net profit margin which is the amount of revenue remaining after accounting for all incomes and expenses. This is the regular or overall profit margin which takes operational expenses, cost of goods sold, payments on debts, one-time payments, taxes, and income from investments into account. Net income is thus the big takeaway which reports the company’s profit and losses after tallying up all costs and earnings. You can gauge the ability of your business to turn income into profit by computing the net profit margin using the formula:

Net profit = Revenue – Cost of goods sold – Operating expenses – Interest – Taxes

Net profit margin = (Net profit ÷ Revenue) x 100

What Is A Good Profit Margin?

A profit margin that is good for one business might not be so for another. It varies between company and industry size. As a rule of thumb, 10% net profit margin is deemed average, 20% is deemed high and 5% is deemed low.

However, it is not advisable to consider a one-size-fits-all approach while setting goals for your business depending on the profit margin. While some companies are low-margin ventures, others have high-margin of profit. You can take the example of retailers and grocery stores which incur high expenses on employees, inventory purchase, renting of a warehouse, shipping, and distribution, etc. Businesses like SaaS companies and consulting firms have high gross profit margins courtesy of low operating costs, less startup capital requirement, and practically no inventory. New businesses have higher profit margins compared to established firms as they have fewer people on the payroll, fewer sales, and lower overhead costs. The margins tend to shrink coupled with expansion in operations.

Tips To Improve Profit Margins

Increasing revenues, reducing expenses, or a combination of both can increase the profitability of a business. You can follow the below-mentioned tips for attaining your desired profit margin:

  • Primarily, you can try and reduce your operating costs like wages and benefits, supplies, materials, utilities, insurance, employee spending, shipping, equipment repair, business software, and shipping.
  • Businesses should also try and lower the rate of or eliminate redundant services. Performing a break-even analysis can help determine the profitability of a product or service. Taking inspiration from peer companies and conducting research can also help perfect the scenario and remove unnecessary expenses. 
  • Demand for a particular product or service is determined extensively by its pricing. Businesses can try and experiment with a variety of product pricing methods like cost-plus pricing or value-based pricing.
  • Businesses can save on their advertising costs by engaging regularly with their customers which helps in retaining them.

The profit margin of businesses varies according to the type of profit chosen for the computation. It is impossible to gauge a holistic picture of the businesses’ financial health by looking at its profit margin alone. However, it can be a great starting point guiding entrepreneurs and managers regarding the points where their business strategy needs adjustment.