Calculating and understanding profit margin

Understanding how to calculate and analyze profit margin is a valuable skill as a small business owner. Your business’s profitability largely determines if your business succeeds or fails. Calculating profit margin will give insight into your business’s financial performance. It allows you to identify areas you can improve to increase your profit.

What is profit margin?

Profit margin refers to the portion of your business’s revenue that you get to keep as a profit. Profit is what is left after you subtract all the business costs from your revenue. Profit margins are typically expressed as percentages.

The three main profit margin metrics are gross profit margin, operating profit margin, and net profit margin – sometimes shortened to simply gross margin, operating margin, and net margin. These metrics show how much money your small business is making after certain expenses are deducted. They also demonstrate how well you handle your business earnings. Finally, they can indicate to potential investors how profitable your business is likely to be over time.

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How to calculate the profit margin percentage for each metric

As mentioned above, there are three primary margin ratios to be aware of when calculating the profit margin for your business: gross, operating, and net.

Let’s assume that we are calculating profit margins for a fictional company called XYZCorp. Below is an example calculation for each profit margin metric for XYZCorp.

Gross margin

Gross profit margin tells you how much revenue your business makes less its cost of goods sold (COGS).

The gross margin formula is:

Gross margin = (Gross profit / Revenue) x 100

Gross profit = Revenue – COGS

Let’s assume that XYZCorp’s revenue for the year is $1,000,000. XYZCorp’s annual cost of goods sold is $600,000. Using the above formula, XYZCorp’s gross margin would be calculated as such:

Gross profit = $1,000,000 – $600,000 = $400,000

Gross Margin = ($400,000 / $1,000,000) x 100 = 40%

Therefore, XYZCorp’s gross profit margin is 40%.

Operating margin

Operating profit margin is your business’s profit after subtracting COGS and operating expenses. Operating expenses include things like employee wages, depreciation, and amortization. Operating profits, however, are pre-tax and pre-interest. This means that it’s revenue available before your business pays any income tax, property taxes, and interest due.

The operating margin formula is:

Operating margin = (Operating profit / Revenue) x 100

Operating profit = Gross profit – Operating expenses

Let’s assume that XYZCorp’s operating expenses are $200,000 for the year. Knowing that the company revenue is $1,000,000 and the gross profit calculated above is $400,000, the operating margin is easy to determine.

Operating Profit = $400,000 – $200,000 = $200,000

Operating Margin = ($200,000 / $1,000,000) x 100 = 20%

So, XYZCorp’s operating profit margin is 20%.

Net margin

Net profit margin refers to how much your business makes after all expenses are removed. Net profit is the same as net income. In addition to COGS and operating expenses, interests and taxes are also accounted for. The net margin metric allows you to compare net income to sales.

The net margin formula is:

Net margin = (Net profit / Revenue) x 100

Net profit = Operating profit – (Interest + Taxes)

Let’s assume that XYZCorp’s interest and taxes for the year totals $50,000. It is known that the company revenue is $1,000,000 and the operating expenses are $200,000. The operating profit calculated above is $200,000. From this, the net margin can be determined.

Net Profit = $200,000 – $50,000 = $150,000

Net Margin = ($150,000 / $1,000,000) x 100 = 15%

So, XYZCorp’s net profit margin is 15%.

High-profit vs. low-profit margins: which is better?

A small business owner learning how to calculate profit margin

After calculating each of the above margins, you may be wondering what the profit margin percentage means. What is a “good” profit margin? The implication of your profit margin percentages will largely depend on the industry your business is in.

A general profit margin guide is:

  • 5% is considered low
  • 10% is considered healthy
  • 20% is considered high

Average profit margins vary based on industry and company size. However, you can use the values above as general benchmarks for your business if you’re just starting out.

A high profit margin is usually seen as favorable. It means you are making a considerable amount of money on a product in comparison to its cost. A low profit margin means the selling price of a good or service isn’t much higher than its cost.

Profit margin next steps

After you’ve calculated the different profit margins ratios above you may be thinking, “now what?” The next step is to perform a profit margin analysis. Profit analyses are a helpful strategic tool. A profit analysis can help you understand your business’s profitability over time.

To complete a profit analysis, simply track your margins over a set period. Are your margins increasing, decreasing, or staying flat? It’s wise to compare your margins to the average margins for your industry. This will help you get an idea of how your business performance compares to your competitors. It is valuable to know where your business stands in relation to your industry.

A profit margin analysis is typically performed over a long period. However, some businesses prefer to look at shorter time periods if it better fits their needs.

Ways to grow profit margins

If you are concerned about your profit margins after performing a profit margin analysis, there are steps you can take. If your profit margin is low, or you are wanting to leverage your margins to grow your business, consider using one of the strategies below:

·      Reduce debt

Performing a cash flow analysis can help you understand how much cash you’re likely to have available at any given time. This empowers you to structure your bills and pay them in cash outright, rather than build up credit card or other debt.

·      Perform an annual profit & loss review

It would be beneficial to perform an annual review of your business’s profit and loss (P&L) statement, or income statement. This will help you to check your budget progress. Then, going forward, you can create a more accurate and attainable budget for the next year.

·      Raise prices

To increase your business’s profit margins, increase your revenue. You can do this by raising prices. Many small business owners start by increasing prices on their unique or popular products and services.

·      Lower discretionary spending

Lowering your discretionary spending, like travel expenses, can also help improve your profit margin. This method doesn’t directly affect your customers, like raising prices does, and thus can be a safer option.

·      Track margins

Good record keeping is crucial to understanding your margins. It is hard to know what steps to take to increase your margins if you don’t know where your books stand. You can track margins yourself or use a bookkeeping service. Block Advisors has small business bookkeeping services that can help you see when and where there has been growth.

The bottom line: understand your costs to increase profits

Calculating profit margins as a small business owner is crucial to understanding your business’s financial health and profitability. Whether your business is just getting started, or you’re a seasoned owner, Block Advisors is here to help.

Our experts can help you with your small business needs. Whether you need bookkeeping services, payroll, or small business tax preparation, we have the resources and tools to help your small business succeed.

Speak with a certified small business tax pro today.

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