A business’ profit margin is a simple method or a beginning, to analyze its route towards achieving maximum financial stability and success. After all, entrepreneurship and business are synonymous with the idea of profit and making money. In this article, we’ll tell you all about profit margin – what it is, how to calculate for it and some examples, By the end, you’ll also know how to improve further in the future!
What is profit margin?
Profit margin is a definitive metric in seeing how much money a business makes and sheds light on its overall profitability as a company. It’s a ratio that compares profit to sales, measuring the revenue percentage that a business keeps after expenditures. Through this, you can gauge the overall financial handling of the company overall. And also something you need to calculate in the process of making income statements.
Why is profit margin important for your company?
Calculating your profit margin is a crucial part of running a company. There are 3 key reasons as to why your profit margins are so important:
1. Long-term profitability measurement
Seeing how much money you’re pulling into your company helps in eyeing what you hope to see your profits look like in the future and pinpointing how to do so. You will get an idea of whether your current profit amounts are sustainable for your business in the long term. Maybe for the sake of the company’s survival, you might need to expect lower profit margins in the future (as long as you’re not at a loss) or perhaps you have the opportunity to raise your profit margins instead.
2. Help to formulate pricing strategies
Speaking of lowering and raising profit margins, calculating your profit margin also provides a base for your pricing strategies on products. You could see that your products are a bit too expensive that they’re not selling all that well, so you might need to lower their prices. Or after considering your expenses and cash outflows, you can raise your prices more to get higher profit percentages.
3. Determine financial problems quickly
Profit margin also assists in assessing potential financial inadequacies early on before they become to much of a problem for your business to handle. You could be spending too much on unnecessary expenditures or you could see profits dwindling as your investments aren’t producing the intended financial gains.
Types of profit margin
There are actually 3 types of profit margins, each pertaining to the different levels of your business:
1. Gross profit margin
This one tells you the profit margin on a certain product that you’re offering. Therefore, it’s used to measure how well a product is selling. Finding your gross profit margin involves knowing how much an item sells for (revenue) and the cost to make it – cost of goods sold (COGS).
2. Operating profit margin
For this, you’re counting the profits you’re earning before taxes and interests. The resulting income figure is usually the available amount to pay to the tax department, equity holders and business debts. This one includes knowing your Operating Income.
3. Net profit margin
When people ask about a company’s profit margin, this is what they usually mean. This is the amount of money you’re left with after deducting all of your expenses. It’s simple maths. All the amount of money that you made, minus the expenditures.
How to find profit margin
The formula for finding the profit margin/net profit margin is very simple:
[ ( Revenue – Total Expenses ) ÷ Revenue ] × 100
For finding gross profit margin:
[ ( Revenue – COGS ) ÷ Revenue ] × 100
COGS = cost of goods sold
As for your operating profit margin:
[ Operating Income ÷ Revenue ] × 100
Profit margin examples
Putting the calculations in practice is also fairly straightforward. Here, we’ll give some easy examples for calculating your profit margins according to the different types:
1. Net profit margin
So we know that the formula is: [ ( Revenue – Total Expenses ) ÷ Revenue ] × 100
Assuming, for this example, total expenses include COGS, operating expenses, other expenses, interest and taxes. Therefore, the formula can be expanded into this:
[ ( Revenue – COGS – Operating Expenses – Other Expenses – Interest – Taxes) ÷ Revenue ] × 100
Let’s say then, that your financial breakdown is as follows:
- Revenue: $20,000
- COGS: $4,000
- Operating Expenses: $3,000
- Other Expenses: $1,500
- Interest: $500
- Taxes: $1,000
Putting those values into the equation:
[ ( $20,000 – $4,000 – $3,000 – $1,500 – $500 – $1,000) ÷ $20,000 ] × 100
You’ll finally end up with a net profit margin of 50%.
2. Gross profit margin
Now you want to find how much profit you’re making from that one single item you sold. We know the formula is: [ ( Revenue – COGS ) ÷ Revenue ] × 100
So, it costs you $15 to make a basket (COGS). You sell that basket for $25. Plugging in these values into the formula:
[ ( $25 – $15 ) ÷ $25 ] × 100
You get a gross profit margin of 40%.
3. Operating profit margin
Here, let’s say you make a revenue of $40,000. Your operating income comes in at $10,000. Knowing the formula and inserting the values:
[ Operating Income ÷ Revenue ] × 100
[ $10,000 ÷ $40,000 ] × 100
We get an operating profit margin of 25%.
How to improve profit margin
There’s always room for improvement. While in the initial phases of your business your profit margins won’t be particularly high, there are ways you can improve them as you go along. Increasing the profit margin is essentially improving on some aspects that might be holding you back. We have several ways you can do so:
1. Evaluate your business strategies
Identify any inefficiencies and take a comprehensive look at your marketing and brand awareness efforts. Evaluate how and where you’re spending money and maybe reorganize your service infrastructure to improve customer experience. Take into account business models that could work for your company and its operations.
2. Reduce operating expenses
Make strategic cuts on your spending. Try to streamline your operating expenses as much as possible. Look into issues like unnecessary staffing, subscriptions or services that aren’t particularly that useful or doing away with expensive office maintenance and items. Maybe even strife to automate tasks where you can to free up some space and time for your staff.
3. Increase the price of products and services
Of course, raising prices will directly increase your profits. But be smart about it too. Don’t overprice to a point where you alienate customers and they go but from somewhere else. The optimum price for your product or service is dependent on your business market. Correctly setting product prices and finding that balance is what get’s you a successful profit margin rise.
4. Elevate your brand and reputation
Your brand’s identity, branding and perceived value to customers and potential buyers are very important in driving sales. It’s recommended that you spend some more to improve the overall quality of your products/services and therefore your brand’s image. And although it might not be that straightforward, combining effective motivation to customers and branding campaigns can also elevate your brand further.
5. Increase customer retention
Improving profit margins also involves keeping your customers happy with your brand and keeping them loyal to you. Retaining your existing customer base takes less money than acquiring new ones. Act on your customers’ feedback and show them that you care by engaging with them.
6. Build stronger vendor relationships
Optimize your relationships with vendors and suppliers. Negotiate better contracts to reduce costs and increase profit margins and even consider building closer relationships with them. Engage in joint business plannings with your vendors and help each other in becoming more profitable.
7. Identify and eliminate waste
Save money by getting rid of wastefulness and raise your profit margin. Identify: defective products in your line, overproducing by ordering/making more than what you need, waiting because of unbalanced workloads, not leveraging your team’s full skill sets, unnecessary movement of products and people, excess inventory collecting dust and overprocessing from sub-par sales and products.
Profits for days
Bottom line is, identifying and continuously monitoring your profit margin is an important aspect to running a successful business, especially when paired with your IRR prospects. After all, as they say, businesses exist to make money and knowing how to maximize your profits is what you need to get there.
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