- Calculate profit margin to understand your growth potential and attract investors and lenders
- Each type of profit margin (i.e., net, gross, and operating profit margin) gives you distinct insights into your business
- Lowering your expenses or increasing your revenue can help boost your profit margin
As a small business owner, you naturally want your venture to succeed. However, business growth isn’t always easy to achieve. According to the Chamber of Commerce, only 40% of small businesses in the United States are currently turning a profit, while 30% are breaking even and 30% are losing cash.
If you want to achieve profitability and increase profits over time, you need to understand how to calculate profit margin to monitor your financial health. Once you understand your ratio of profit, learn how to track and improve it with this guide.
What is a profit margin?
A profit margin is a financial ratio that tells you the fraction of each dollar of sales that stays in your business. For example, if your profit margin is 0.4 (or 40%), you’re making 40 cents of profit per dollar of sales. The other 0.6 of your revenue goes toward your expenses.
Your profit margin shows if your business is making money—and to what degree—so you can gauge its growth potential.
Why do I need to calculate profit margin?
Your profit margin is a vital metric for understanding your business’ financial health. When you calculate profit margin, you learn how your expenses are impacting your business growth. If your profit margin is lower than average (i.e., under 10%) you can adjust your pricing strategy or overall business strategy to increase it.
Calculating profit margin is also essential if you plan to pitch to investors or apply for business loans. Lenders and investors often expect to see your profit margin, as it’s considered an indicator of your company’s ability to profit and grow. A high profit margin (i.e., 20% or higher) can also indicate strong business management skills.
Types of profit margins
While profit margin is always defined the same way, there are three different types of profit margins that give unique insight into your business. Below, learn the three profit margin formulas and how to use them.
1. Net profit margin
This is the financial ratio that most people think of when calculating profit margin. Net profit margin is your company’s bottom line. It gives you the full picture of your company’s profitability by taking into account all your expenses and revenue.
Before you do your net profit margin calculation, calculate your net income using the following formula:
Net income = total revenue – total costs
Your total costs include all business expenses, such as fixed costs (e.g., rent), production costs (e.g., shipping expenses), taxes, debt payments, interest, depreciation, and amortization. If you currently use accounting software or work with an accountant, you can find these expenses on your income statement.
Once you know your net income, use this formula to calculate your net profit margin:
Net profit margin = net income ÷ total revenue
For example, if your total revenue is $5,000 and total costs are $3,000, your net income would be $2,000. Dividing $2,000 by your total revenue (2,000 ÷ 5,000), you learn that your net margin is 0.4.
Multiply your result by 100 to see your ratio of profit as a percentage. In this example, your net profit margin percentage would be 40%.
2. Gross profit margin
Gross profit margin shows how much you’re profiting in direct comparison to your production costs alone—the expenses directly related to producing your product or providing your service. These expenses are known as your cost of goods sold (COGS).
When totaling your COGS, include the direct costs of sales, such as raw materials, inventory, packaging, shipping, and labor associated with production or sales. Don’t include indirect costs like overhead costs or loan payments.
Then, plug your numbers into this gross profit margin formula:
Gross profit margin = (total revenue – cost of goods sold) ÷ total revenue
In the previous example, your total revenue is $5,000, but let’s say your COGS makes up $2,000 of your total costs. Your gross profit margin calculation would look like this:
Gross profit margin = (5,000 – 2,000) ÷ 5,000
Gross profit margin = 3,000 ÷ 5,000
Gross profit margin = 0.6
Gross profit margin will always be higher than your net profit margin. It’s a great way to understand how much of your total costs go toward COGS, and investors will use it to determine if executive management is effectively deriving profit from sales.
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3. Operating profit margin
Operating profit margin calculates your profit with COGS and day-to-day operating expenses. This profitability metric shows how all the costs of operating affect your growth and tells investors if your company is making most of its income from its core service/product or other means.
For this metric, calculate your operating income with the following formula:
Operating income = total revenue – COGS, operating expenses, depreciation, and amortization
Then, use this formula to find your operating profit margin:
Operating profit margin = operating income ÷ total revenue
If your total revenue is $5,000 and your operating costs (including COGS and other operating expenses) make up $2,500 of your total costs, your operating income would be $2,500. Dividing $2,500 by $5,000, you’d find that your operating margin is 0.5.
3 ways to improve your profit margins
The definition of a good profit margin varies greatly between industries and for small businesses versus large corporations. In general, think of 5% as low, 10% as average, and 20% as high. No matter where you start, improving your company’s profitability is always a great goal. Here are three ways to increase your profit margin.
1. Lower your business expenses
Minimizing your business expenses is one of the easiest ways to boost profit margins. If COGS makes up a significant portion of your expenses, focus on lowering these costs first. If your operating costs are high, determine ways to reduce them, such as automating tasks with technology, identifying inefficiencies, and outsourcing certain business processes.
Remember that lowering business expenses is about balance. You still want to maintain the same quality of product or service that your customers are used to. Rather than using cheaper materials or equipment to cut costs, find strategic, sustainable alternatives—for example, build relationships with more affordable suppliers.
2. Increase your selling price
Sometimes, a low profit margin means you’re undervaluing your products or services. Compare the prices of your products or services to your competitors’ to determine if you’re charging below average.
If you determine your sales prices are adequate, you might still want to raise your prices over time to improve your profit margin. Brand marketing—which involves creating a distinct identity for your business—is a good place to start. When your brand is strong, recognizable, and widely trusted, customers will be willing to pay more for your products based on your brand name alone.
3. Start upselling and cross-selling
Not ready to increase your prices? You can still boost your total revenue with two sales strategies:
- Upselling: encouraging customers to upgrade to a more expensive product (for example, a large drink instead of a small drink)
- Cross-selling: encouraging customers to purchase more items (for example, by offering bundles)
To incorporate these strategies, hire well-trained sales staff or plan strategic marketing campaigns to show customers how higher-end options or additional products will improve their customer experience.
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Calculate profit margins for more informed decisions
As a small business owner, your business has many different types of impacts: helping customers, creating community, and meeting a need in your market. But if you want to continue growing, calculating your profit margin is essential to future success.
When you can track your company’s profit margin, you can make smarter decisions about your pricing, expenses, and overall financial health. Get more small business accounting tips to further improve your company’s profitability and stability.
The information above is provided for educational and informational purposes only. It is not intended to be a substitute for professional advice and may not be suitable for your circumstances. Unless stated otherwise, references to third-party links, services, or products do not constitute endorsement by Yelp.