What is profit margin?
As a business owner, it’s important to not only know how much revenue your company is generating, but how much profit you’re actually making from that revenue.
That’s where profit margin comes in. Not to get confused with EBITDA the profit margin formula is different:
Net income / (Divided by) Net sales
you can find out how much profit you’re taking in after you’ve paid for all your basic business expenses (in most industries, somewhere between a 5-10% profit margin is typical).
Those deductions can include:
- Production costs
- Material costs
- Business taxes
- Interest
- Depreciation
- And other costs
With profit margin, you know how much you’re making on every individual sale, which makes it the starting point if you’re trying to figure out how to bring in more cash to your business.
Calculating your profit margin also helps tell you if there are any problems. If you’re not bringing in enough profit, by calculating your profit margin you can go back through those numbers and see why they’re not larger and where your major costs exist that are keeping your margin small.
How to calculate profit margin
To calculate your profit margin, use this formula:
To figure out what your net income and net sales are to run the profit margin formula:
- Net income: Subtract your total revenue by your total expenses
- Net sales: Subtract your total sales by returns, sales/any other discounts, and allowances of any kind.
Once you have your net income and net sales, calculating your profit margin is a simple matter of running the formula.
However, keep in mind that there are two different kinds of profit margin calculations you can run:
- Gross profit margin
- Net profit margin
Let’s talk about how to calculate each:
How to calculate gross profit margin
Gross profit margin is useful if you’re trying to get an idea of the profit on a single product sale, which can help you figure out if you need to reduce material or production costs.
Here’s how to calculate gross profit margin:
Product price – Cost of materials and production (labor)
Let’s look at an example using the gross profit margin formula:
Gross profit margin example
Mark owns a liquor store. He sells all kinds of products, but makes a lot of his money on alcohol sales.
He wants to figure out how he can maximize his profit on the sales of some of his best-selling alcohol products, so he wants to figure out his gross profit margin on several of his bestsellers.
His best-selling liquor is a bottle that sells for $30 even. He purchases that liquor and many others from a single vendor. In this case, he purchases his best-selling liquor for $23.
If his sales price is $30 and his purchases price is $23:
$30 Sale – $23 Purchase Cost = $7 Gross Profit (Per Bottle Sold)
He makes $7 per bottle of that particular liquor he sells.
How to calculate net profit margin
As opposed to gross profit margin, the net profit margin formula is useful for figuring out your entire business’s profit margin.
Here’s how to calculate net profit margin:
Your Net Income (for X Time Period) / (Dividing by) Net Sales = Net Profit Margin
Let’s look at an example using the net profit margin formula:
Net profit margin example
Let’s say you own a rustic-inspired restaurant and bar that generates about $100,000 a month.
If you’re trying to figure out your net profit margin for the past year, you’d take that $100,000, multiply it by 12 months ($1,200,000), and then take that annual net sales amount and divide it by your income.
If you bring in an average of about $10,000 in income per month, multiplied by 12 ($120,000):
$120,000 Net Income / (Divided by) $1,200,000 = 10%
Your profit margin is then 10% (which fits, as the average restaurant sits at around 3-15% profit margin).
What is a good profit margin?
So, we’ve talked about how to calculate your net and gross profit margins. But what is a good profit margin? Where should your business be at to make sure you’re maximizing each sale, promotion, and other marketing efforts?
For the most part, what a good profit margin is depends on the industry of your business. Profit margins can differ somewhat, though most businesses fall within the 5-10% area.
You might have to pay for an annual license (like a liquor license), for regular consulting, leasing, various types of insurance, and depending on what kinds of products you offer, your costs will vary wildly.
Here are some examples from recent studies (here, and here) on the average profit margins based on more than a dozen industries:
Tips for improving your profit margin
Now that you have a better idea of what kind of profit margin you might shoot for, let’s talk about how to get there.
How can you improve your profit margin? Because both types of profit margin cover the gamut in terms of your business costs, there are a lot of places you can start.
Here are a few tips for improving your profit margin:
1. Raise the price on products whose production cost is too high
Maybe your net profit margin as a whole is being weighed down partly due to a few products whose gross profit margin is too low.
Now that you’ve calculated your profit margins, that data should start to become clear.
In that case, you can decide to either discontinue those products or raise their price all depending on how they sell, their necessity to your catalog, whether you feel your customers will buy them at an increased price, etc.
2. Reduce or cut expenses
Are you paying too much for materials? Can you find the same price elsewhere for cheaper, or purchase a cheaper alternative?
How much are you paying for labor? Packaging? Delivery? The list goes on.
These are all questions you’re going to have to answer for yourself, and whether you can reduce them, replace, or cut them entirely is up to you.
However, reducing or cutting expenses is one of the most effective ways to improve your profit margins because you’re not raising the price of your product, which has obvious sales implications.
3. Discontinue underperforming products
The more varied materials you need for your product catalog, the more difficult it becomes to manage everything, from costs to production and storage.
If you have certain underperforming products, especially those whose materials are either difficult to get a hold of or expensive, consider cutting them to focus your catalog of products on those that are moving.
It’s your sales– Learn how to make the most of it
Maximizing your profits is an important part of any successful business, but it becomes even more important for a small business that needs to maintain extra cash on hand for unexpected events.
Knowing how to calculate your profit margin, both gross and net profit margin, is important as they give you a window into your business that tells much about its health.
Often, fixing problems with net and gross profit can remedy chronic concerns that would eventually become serious issues.
Learn how to calculate your profit margin so you can be sure you’re not just making the most from each sale, but that your business cash flow is healthy.
