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The profit margin of any business is an important barometer of its health and potential longevity. In addition, knowing your business’s profit margin allows you to make informed decisions regarding its future and goals.
Defining Profit Margin
One of the most important indicators of a successful business is its profit margin. You need to understand what is meant when the phrase “profit margin” is mentioned.
In its simplest terms, your profit margin is a metric that indicates how much money a business is making. It is a measurement of how effectively the business uses its earnings to pay for its expenses.
The profit margin of a business is a reflection of the revenue percentage that your business retains. You can determine the profitability of your business for a specific time frame by knowing how to calculate its profit margin.
Even though some business owners think that profit margin is the same thing as net profit, the two financial terms have different definitions. While profit is expressed as a dollar amount that remains after you subtract all your business expenses from its earnings, it is not a percentage.
Helpful Definitions to Know
Some business terms are so closely related that teasing out their differences is necessary to obtain clarity.
- margin: this term applies to the markup you tack on to every product or service offered by your business so that a profit is made with each sale.
- cost: the bottom line amount that it takes your business to produce a service or product. It takes into account the cost of both materials and labor as well as variable costs. Knowing the cost assisting you in planning your profits.
- revenue: when the profit and cost are combined, the result is revenue. It is the final amount that a customer pays for a particular product or service. Use this figure to help you determine the success of each of your offerings.
- profit: by subtracting your costs from the revenue your business receives, you arrive at your profit. It’s essential that you know the profit your business receives. Additionally, in order to fuel growth, your business must see a consistent increase in profits.
Net and Gross Proft Margins: Both are Valuable to Know
The profit margin of a business can be categorized as either gross or net. Both metrics are valuable to know because they let you examine profitability in different ways.
As a measurement, the gross profit margin helps you determine how profitable a single service or product is for your business. Once it’s calculated, you’ll discover which items are profitable compared to others.
To determine the profitability of your business as a whole, however, you need to determine its net profit margin. This measurement compares your business’s expenses and total earnings. When a business’s profitability is talked about, its net profit margin is usually what is meant.
How to Calculate Profit Margin
The formula to correctly calculate your business’s profit margin is simple. This makes it a convenient and handy tool for staying informed about your finances.
It consists of a three-step process. First, you’ll need to find the net income for your business. This is obtained by subtracting its total expenses from its revenues.
Next, you need to divide your net income by the business’s revenue. Lastly, multiple that number by 100 so you are left with a percentage.
Real-Life Example
Understanding your business’s profit margin is essential to ensuring that it is growing, moving forward and meeting goals. Knowing the profit margin is also beneficial if you want to secure a business loan or engage in a similar financial transaction.
Suppose your business wants to obtain additional capital so it can expand in a particular area. Gathering crucial data to present to potential investors provides them with a picture of the business’s health. This example uses round numbers for illustration purposes.
Calculate Gross Profit
Using your business’s income statement is a good place to start. If your business has revenue of $100,000 but the cost of the products or services sold is $38,000, that leaves it with a gross profit of $62,000. Next
Determine Total Expenses
For the purposes of this example, your payroll — which is your business’s largest expense other than the cost of the products or services provided — is $22,000. Insurance is $8,000, rent comes to $6,000 and miscellaneous supplies run about $1,000. This means the total expenses for your business are $37,000.
Calculate Your Net Income
In order to calculate your business’s net income, simply subtract its total expenses from its revenue. Remember that this figure not only includes the operating costs for the business ($37,000 in the example), but also the cost of the products or services you sell ($38,000 in the example).
Your business has $75,000 in total expenses (operating costs plus the cost of goods). Since your revenue is $100,000, then your net income is $25,000.
Next, you’ll need to divide your business’s net income by its revenue. This means that $25,000 in net income is divided by $100,000 in revenue which equals 0.25.
Finally, multiple that number of 100 to get a result that is a percentage. 0.25 multiplied by 100 equals 25 percent. This means that after your business pays out for its expenses, it keeps 25 percent of its earnings.
Using Profit Margin Data
In addition to showing potential investors that your business is generating a profit, finding out the profit margin is also helpful in determining how it is using the money it does bring in. The profit margin that is standard for a business depends heavily on the industry that it’s in. It’s also important to remember that the average profit margin for a particular industry can range several percentage points.
Staying on top of your profit margin gives you the tools you need to make an informed decision should you discover that your business is not as profitable as you would like. You’ll be able to examine the different categories of expenses and costs to determine if there are ways of boosting sales or reducing expenditures.
