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Money isn't everything, but for small business owners, it often feels as though it is. With so many factors reliant on a stable income, financial concerns dominate operations of all kinds, and it's not uncommon to find yourself asking, "am I making enough money?"
The answer may be yes, or it may be no, but simply looking at revenue isn't enough to gain an accurate view of your financial situation. To determine how you stand, it's important to understand both how to calculate profit margin as well as what that figure means for your small business.
Why profit margin matters
Simply put, profit margin refers to the amount of profit you can achieve in relation to revenue, whether on a single transaction or the overall state of your business. A high-profit margin implies significant gains relative to the amount spent, while a low-profit margin or, worse, a negative profit margin means you are on the cusp of losing money rather than turning a profit.
While profit margin in a vacuum doesn't mean that much, it can be very telling when viewed through the right lens. For example, suppose the gross margin on your primary product is only two percent. In that case, you may need to find a way to raise prices or reduce the expense of sourcing or production, but if you're seeing margins around 60%, you're in a good position to drive substantial earnings.
Calculating profit margin
Profit margin comes in two forms: gross profit margin and net profit margin.
According to Investopedia, gross profit margin is the profit achieved before factoring in operating expenses, like salaries and rent. Gross profit is the difference between revenue and cost of goods sold, and gross profit margin can be found by dividing gross profit by total revenue.
For example, your business makes $100,000 a year and spends $70,000 on the total cost of the merchandise. With these figures in mind, the gross profit margin would be 30%. Without adequate gross profit, it's not possible to cover costs related to overarching operations. While gross profit margin is an important metric, it cannot help you determine overall profitability and is thus better used on a product or service level.
Investopedia also states that net profit margin compares total income to total expenses to determine the overall performance of your operations. To find net profit margin, take all revenue for a period and subtract all expenses for that period and then divide by total revenue.
For example, if you made $100,000 in revenue, spent $70,000 on the cost of goods sold, and invested another $25,000 in additional expenses, your net margin equals five percent. Having this number in the back of your mind can be an important part of understanding and evaluating your financials, guiding the course of business in the right direction.
Determining a good profit margin for your business
So, you know how to calculate your margins, but what exactly does that mean? Is five percent good? Is it bad? How does it compare?
Before taking a deep dive into analysis, it's important to understand the variation in profit margin across various industries. In low-cost fields, a five percent margin, for example, may raise red flags, but in an area with significant overhead, this could be at the top of the market.
As with many aspects of small business, industry plays a significant role. Rather than sounding the alarm because your margins look low, take time to verify how your margins relate to your field. For example, profit margins over 15% may be common in fields like accounting and bookkeeping services, auto equipment leasing and rental, and dental offices, while industries like auto dealers and senior care centers may have an average margin closer to three percent.
To determine the averages in your market, consider exploring industry publications and academic research, like this data from the NYU Stern School of Business. The more due diligence you can do, the better; a thorough comprehension of your financial position is critical to business success.
Planning next steps
If your profit margin is in line with or above industry norms, you're already on the right track, but if you're falling short, it's likely time to take action. While the savings opportunities available to you will vary, common strategies include:
- Raising prices, being careful not to exceed industry norms
- Improving up-selling and cross-selling
- Increasing inventory turnover
- Eliminating low-margin clients, products, or services
- Making efforts to reduce attrition and improve retention
- Carefully monitoring spoilage and waste
Strong financial performance goes well beyond revenue; how expenses factor in can be equally important. By understanding the ins and outs of profit margin calculations as well as the standards in your industry, you can be sure you're on course for sustainable success.
For more information
For more information to help your small business, check out the BBB business news feed and the BizHQ.
BBB Great West + Pacific contributed to this article.