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A business measures its earnings by its profit margin, which it can calculate with the profit margin formula. Unfortunately, you cannot measure your earnings by the sales price of your products or service alone. And since only 40 percent of small businesses are profitable while 30% break even, it’s important to stay aware of your business’s financial health. Since there are often smaller returns for small business owners than large corporations, small business owners must ensure they have larger profit margins to get a better rate of return on their investment and keep their doors open. However, don’t be nervous, there is hope! By learning how to calculate profit margins and make more educated decisions in your business, you can increase your odds of success. Read on to learn how to calculate different types of profit margins, including the gross, net, and operating profit margin ratio formulas.
What is a Profit Margin?
A profit margin is the figure that represents how much money a product, service, or business makes after expenses. It’s expressed as a percentage: the higher the number, the more profitable the business.
In your business plan, there should be a section that covers products and services. Here you can break down all of the expenses that make up the product or service. This will allow you to plan the appropriate budgets and project cash flow for a better chance of success.
Knowing your profit margin number is key because it can help you:
- Price Accurately. Once you know your profit margin percentage, you can analyze whether your prices are too high or too low. If you’re ready for this step, check out our guide on pricing your products.
- Monitor Expenses Effectively If there is a service or product that is not performing at the level needed, you can decide to remove that item or make the necessary changes.
- Make Smarter Decisions. You can pinpoint which items have a low profit margin and find the cause of the issue.
- Appeal to Lenders. Lenders will request information regarding the business’s profitability, so keeping products/service profit margins up will make it easier to obtain a small business loan.
The Types of Profit Margin
There are three major types of profit margins that every business owner should calculate. These three figures will help you get a solid sense of your financials. They include gross profit margin, operating profit margin, and net profit margin. These numbers will provide valuable insight into where changes are necessary and which products/services provide powerful results. Let’s review each.
Gross profit margin
The gross profit margin will show you the profit earned after subtracting the cost of goods. The only expenses included in this number are the ones you need to manufacture the product. For example, this includes the cost of labor or raw materials.
Any other expenses such as overhead costs or taxes are not included in this calculation.
Operating profit margin
The operating profit margin includes the cost to produce and manufacture a product, as well as the overhead expenses to operate the business. This formula is a great tool to help you figure out if you are managing your expenses properly.
Net profit margin
Net profit margins take all business debts, obligations, non-operating, and operating expenses into account. This will help you find out how much you earn in profit compared to your revenue.
The Profit Margin Formula
The profit margin formula is simple to use as long as you understand its two components: Net sales and net income.
You calculate net income by subtracting your total expenses from your revenue. You can get net sales by subtracting any allowances, returns, and discounts from the gross sales value. The profit margin ratio formula looks like this:
Profit Margin = Net income / Net Sales
Gross profit margin formula
The gross profit margin formula is:
Total Revenue – Cost of Goods Sold / (Total Revenue x 100%)
After applying this formula, you will have a clear idea of how much profit you get to keep after paying the cost to produce it.
Net profit margin formula
Now that you know what net profit margin means, you can use it to find out where your business stands. The net profit margin formula is:
Operating Profit – Interest Expenses – Tax Expenses / Revenue X 100
Operating profit margin formula
The operating profit margin formula is also easy to use. The formula looks like this:
Operating Income / Net Sales Revenue X 100
With this figure, you can see at a glance how your production and operation costs affect your revenue. This is a great way to manage your expenses. This formula can help you see if you’re spending more in these areas than you need to be.
Margin vs. Markup
To understand these figures better, it’s critical to understand the difference between a markup and margin, as they are not the same. A markup is the percentage amount used to increase the cost of a product to the selling price. In sharp contrast, margins refer to the revenue earned after paying for the cost of goods sold.
How Can You Improve Your Profit Margin?
By applying the gross profit margin formula, net profit margin formula, and operating profit margin formula, you will have a clear idea of which products are creating more revenue and profits. It will also become apparent which are affecting the business negatively.
If you find that you have a group of items that have low profit margins, there are a few methods to help them increase:
- Remove low performing items. It may be simplest to remove a low performing item and replace it with one that will generate more profit.
- Reduce expenses. You may find that more cost effective packaging and labels or new technologies that boost efficiency and reduce time constraints can dramatically increase profit margins.
- Use discounts strategically. As you now know, not all products/services have the same profit margins. By using a discount code that applies to all items, you may be hurting your business. Only use promotional codes for items that have enough margins to support them.
- Increase your brand’s perceived value. Convincing customers that your items are worth a higher price tag can dramatically increase your bottom line.
The majority of small businesses cite failure due to cashflow issues. This can be avoided through careful application of profit margins and consistent monitoring of these figures.
Using a profit margin ratio formula in your business is essential. It will not only help your business stay financially healthy but also ensure you are allocating your time and resources wisely. Don’t become a statistic. Take the necessary steps to calculate profitability and ensure your company can thrive and not just survive.