The Hustler's Digest StaffProfit margins determine how much money you are making and represent the overall financial health of your business. Read this article to learn what is a good profit margin and its importance in business.
Businesses should pay attention to their profit margin, indicating a company’s fiscal health. Profit margins measure how well a company is doing. Business owners should always know how their organization spends money to optimize profits. It exhibits how much profit you make on every pound of revenue after deducting all operating expenses, interest and taxes. It demonstrates the overall success of your business, which is why it is so essential to analysts and shareholders.
It’s essential for business owners and stakeholders to know your profit margins and track them. Your business needs to make money to keep afloat, and monitoring your margins helps you see the health of your business and tells you if your company can grow. Whether you’re a well-established company or a startup working out of a garage, you should understand your profit margins.
If you are reading this, you must wonder what the profit margin is? How to find out if the it meets the business expectations. Profit margin is a measure of its earnings relative to its revenues. There are three main profit margin metrics: gross, operating, and net profit margin. Let’s discuss these metrics and how they define the company’s financial credibility in-depth and learn what is a good profit margin.
What is a profit margin?
Profit margin is the measure of your business’s profitability. It is expressed as a percentage and measures how much of every dollar in sales or services your company keeps from its earnings. There are three metrics to profit margin, i.e. gross, operating, and net profit margin. These profit margins are essential key performance indicators (KPIs) to follow in your business. As your business grows and revenue grows, your profit margins should stay tight or increase, and if they are decreasing, this is a red flag.
Business owners should know the profit margins in their business. You need to know the overall operating, net, and profit margin for each product and service. These indicators will let you know which product is the most profitable and makes the business the most money. Let’s help you understand the three metrics.
Gross profit margin
The gross profit margin tells you what your business made after paying for the direct cost of doing business, including labor, materials and other direct production costs. Evaluating it is difficult because every business is unique. For example, companies prioritizing sales volume amongst their strategies or operating in highly competitive markets trend towards lower gross profit margins despite maintaining healthy finances.
Operating profit margin
You can obtain operating profit once operating expenses have been deducted from gross profit. It is also known as EBIT (earnings before interest and taxes). It represents how efficiently a company can generate profit through its core operations. Financing activities like interest on debt obligations are categorized as a non-operating expense because decisions on how to finance a company are discretionary to management. There are generally two sources of raising funds, i.e. using debt or equity.
Net profit margin
Net profit margin is the most complex type to track, but it gives you the most insight into your bottom line’s financial problems. Monitoring your net profit margin is a critical component in understanding how profitable your small business is and where you can trim unnecessary expenses. It indicates how much profit you make on every dollar of revenue after deducting all operating expenses, interest and taxes. It demonstrates the overall success of your business, which is why it is so essential to analysts and shareholders.
Your company’s profit margins reflect the overall profitability of your business relative to its gross sales. While many companies are looking to grow to focus their efforts on increasing sales, improving profit margins is another way business owners can drastically increase their profitability. A business can make more from every dollar of gross revenue by broadening its profit margins. Let’s discuss a few factors that could help you optimize.
Tracking expenses
You should always know how much money your business is spending. One of the most important steps in improving your profit margins is tracking expenses. If you don’t see what you’re spending money on, how can you cut costs and improve your profit margins?
Gross vs net profit margins
Suppose your gross and operating margins are healthy, but your net profit margin shows issues with the bottom line. In that case, you have both unnecessary operating costs and overhead you can cut. If the problem shows up at the level of the operating profit margin, your operating costs are more than you can cover at the price you’re charging for your goods or services.
Profit margin formula
As we mentioned earlier, there are three types of profit margins: gross, operating, and net profit margin, which help measure the company’s profitability. The profit margin is a ratio of a company’s profit (sales minus all expenses) divided by its revenue. This ratio compares profit to sales and tells you how well the company is handling its finances. It’s always expressed as a percentage.
For each profit margin, the formula is slightly different. Let’s learn each margin’s formula and its calculation.
Gross profit margin formula
This margin compares revenue to variable costs. It tells you how much profit each product creates without fixed costs. Variable costs are incurred during a process that can vary with production rates (output). Firms use it to compare product lines, such as auto models or cell phones.
Service companies, such as law firms, can use the cost of revenue (the total cost to achieve a sale) instead of the cost of goods sold (COGS). To determine the gross profit, you will use the following formula:
Sales – Cost of goods sold = Gross Profit
Once you have gross profit, you can easily find gross using the following formula:
(Gross profit / Net Sales)*100
Operating profit margin formula
Operating profit is calculated by subtracting all COGS, depreciation and amortization, and all relevant operating expenses from total revenues. Operating expenses include a company’s expenses beyond direct production costs, such as salaries and benefits, rent and related overhead expenses, research and development costs, etc. The operating profit margin calculation is the percentage of operating profit derived from total revenue. Here is an easy formula that you can use to calculate operating profit margin:
(Operating income / Net sales)*100
Net profit margin formula
The net profit margin ratio is the percentage of a business’s revenue after deducting all expenses from total sales, divided by net revenue. Net profit is total revenue minus all expenses:
Total Revenue – (COGS + Depreciation and Amortization + Interest Expenses + Taxes + Other Expenses)
Using net profit, you can find the net profit margin by the following formula:
(Net profit / Net sales)*100
What is a good profit margin for clothing?
Suppose you run small clothing retail shops or speciality shops within larger stores that sell fashionable clothes and accessories, gifts or exclusive merchandise. In that case, you must mark up your goods correctly so that your target buyer can afford them and you maintain the profit needed to flourish. If you are new in this industry, you must know that the profit margin metrics are an important indicator to check the financial ability to meet expenses and re-invest in the business.
Profit margins for retail clothes are generally within a range of 4 percent to 13 percent, according to industry analysts. Markups often seem high as compared to cost of goods sold, another term for variable costs. When all costs are considered, the profit the clothing company earns is much lower, and to stay in business, clothing retailers need to sell a high volume of merchandise.
The clothing industry is highly competitive, and as a result, performance metrics can become detailed and tiresome. For a small business, however, basic metrics are sufficient to assess the business’s financial status and overall health. Profit margin is a critical metric that tells a business the percentage of profit it receives from each dollar in sales.
How to calculate profit margin?
Though there are three different ways to calculate a company’s profit margin ratio, here are the steps for calculation in the simplest form:
Calculate the net sales
First, you need to determine the company’s net sales by following this formula:
Net sales = revenue – returns, refunds and discounts
Determine the net income
Next, you calculate the net income by using this formula:
Net income = revenue – total expenses
Find the profit margin ratio
Finally, after calculating the net income and net sales you can find the profit margin ratio by employing this calculation:
Profit margin = (net income / net sales) x 100
How to interpret the results?
The profit margin ratio determines what percentage of a company’s sales consists of net income. It provides a measurement of how much profits are generated from a company’s sales. This number helps determine how well an organization’s finances are being managed.
Companies strive for higher profit margin ratios which means that their profits will exceed their expenses. They accomplish these higher ratios by either lowering expenses or increasing revenues. Though generating more revenue would be a preferred solution, it is often more difficult than reducing spending budgets. Therefore, most companies cut expenses to improve their profitability. Additionally, this figure can be used to compare a company’s current and past performance and compare similarly-sized companies in the same industry.
Example: net profit margin
For this example, let’s say you didn’t know what your business’s net income amount is. Because you don’t know the net income amount, use the following formula:
Net Profit Margin = [(Revenue – COGS – Operating Expenses – Other Expenses – Interest – Taxes) / Revenue] X 100
To find your net income, follow the first part of the formula, which is subtracting various expenses from your revenue. Here’s a breakdown of the expenses you need to subtract from your revenue:
COGS: $4,000
Operating expenses: $3,000
Other expenses: $1,500
Interest: $500
Taxes: $1,000
Your revenue is $20,000. Your total expenses add up to $10,000. Plug your totals into the formula from above to find your net profit margin.
[($20,000 – $4,000 – $3,000 – $1,500 – $500 – $1,000) / $20,000]*100
[($20,000 – $10,000) / $20,000]*100
Your business’s net profit margin would be 50% or 0.50 [($10,000 / $20,000)*100].
If you already know your net income amount, you can skip subtracting your expenses from revenue and simply divide your net income by your revenue, then multiply the total by 100.
Example: gross profit margin
Say you want to find the gross profit margin on a product you offer. To find the gross profit margin, you need to know how much the item sells and how much it costs to make.
Say you sell a shirt for $25. It costs $15 to make the shirt. To find your gross profit margin, put the amounts into the formula below:
Gross Margin = [(Total Revenue – COGS) / Total Revenue]*100
Gross Margin = [($25 – $15) / $25]*100
Your business’s gross profit margin is 40%, or 0.40. This means you make 40% on every shirt you sell.
Example 3: operating profit margin
Suppose you want to find your business’s operating profit margin. Your operating income is $10,000, and your revenue is $40,000. Enter your operating information into the operating profit margin formula.
Operating profit margin = (Operating Income / Revenue)*100
Operating profit margin = ($10,000 / $40,000)*100
Your company’s operating profit margin is 25% or 0.25.
Profit margin calculator
Businesses looking to grow will need to be aware of their financial journey and how much money they’re making. One way to do this? Keep track of your profit margin. A profit margin is a way to measure how much your company is earning. You may also know it as calculating your profits about your revenue. Your profit margin will determine how much profit your business generates for each dollar of sale.
Not everyone has a grip on profit margin formulas and its in-depth understanding. There are several online calculators available that are reliable and easy to use. Online profit margin calculators are convenient for those who can not manually calculate profit margins. Therefore, if you do not plan to calculate your profit margin yourself, don’t worry; you’re not alone. There are plenty of online resources to help you calculate your profit margin without doing the math yourself. Let’s give you an overview of these calculators.
The omni calculator
It is a free online tool that helps calculate profit margin when you consider your product or service’s sales revenue. The margin calculator also assumes the cost of goods sold, profit margin, revenue and profit. The omni calculator is up-to-date and has many features that make the calculation easy for you.
Calculator soup
Calculator soup is another free online tool that helps you calculate your gross profit margin. You can also determine your mark-up percentage and gross profit of a sale from the cast and revenue of an item. Businesses can access this profit margin calculator that simplifies this process. With the help of a profit margin calculator, companies can ensure their operations and pricing strategies are delivering the desired results.
The calculator site
The calculator site has three free calculators: a gross profit margin calculator, a sales margin calculator, and a net profit margin calculator, all for free. The online calculator has several customizations for businesses.
BKL
The BKL is another online calculator that helps you calculate the profit margin for your company. However, it has only one option currently to calculate your business’s gross profit margin.
Oberlo
Calculating your profit margin has never been easier with the Oberlo online calculator. It’s more simplistic than other options, for sure, but it does help you calculate your baseline measure of profitability.
Shopify
The Shopify profit margin calculator is a simple, free way to determine what prices to sell your products to maximize your profits and increase your profit margin.
Average profit margin by industry
Why should you know the average profit margin by industry? Increasing your profit margin should be your ultimate goal as a business owner. Profit margin measures your business’ profitability and is an excellent indicator of your company’s financial health.
But even if you have calculated your profit margin, it can be challenging to know if it is what it should be. What is a good profit margin? Should you get financing to increase your profit margin? To answer those questions, first, you have to compare. By looking at the average profit margin by industry, you can see how your business compares to others in the same sector. This information can help you determine whether or not your business is in good shape.
As you would expect, COVID-19 has significantly affected practically every sector. The typical gross profit margin by industry and industry’s typical net profit margin has changed because of the pandemic. So here’s a quick review of how the pandemic changed the average profit margin by industry:
Auto repair & maintenance
Car sales were nosedived in 2020 as stay-at-home orders came into effect. According to data provided by J.D. Power, new car sales saw a fall of 45% in April compared to the previous year.
Thanks to the lockdown, traffic accidents fell sharply, and accident-claim rates plummeted to a 50-year low. While this is excellent news, it affected the auto repair industry. CSIMarket reveals that the automotive aftermarket sector’s net margin fell to 2.45% in 2Q2020.
Construction
COVID-19 had a dual impact on the average profit margin by industry (for construction). On the positive side, costs like energy went down. But this was offset by the fall in demand. Dodge Data & Analytics, a firm that provides software-based workflow integration solutions for the construction industry, estimated that commercial construction was down by 16% in 2020. You must wonder what effect has this had on profit margins? Net margins in the industry stand at a respectable 6.24%. The decrease in costs has likely compensated for lower business volumes.
Hotels & hospitality
Health concerns and stay-at-home orders damaged the hotel industry because of a steep fall in demand. The extent of the impact on hotel revenues can be gauged by this illustration that shows the monthly average revenue per available room of United States hotels from 2011 to 2020.
Maintenance
Maintenance services companies had to ensure the highest hygiene standards at client sites. Consequently, costs went up. There was an increased expenditure on face masks, hand sanitizers, hand wash, and disinfectants. The higher level of spending by facility management companies impacted their profitability.
Food industry profit margin
COVID-19 has had a massive impact on the profitability of the restaurant industry. Almost 5.5 million chefs, waiters, and other restaurant staff were out of work in April. Pre-COVID, full-service restaurants were making net margins of about 15%. However, during the pandemic, many of them were making losses. It is essential to consider the food costs in this calculation. Restaurant owners need to view all the variables carefully for the profit margin equation. This applies to all types of restaurants, including quick-service restaurants.
What does profit margin depend on?
Your company’s ideal profit margins depend on different industries, expansion goals, and size.
Industry
Knowing the average by industry is essential when setting goals for your business.
Companies in the restaurant and foodservice industry, for example, typically have lower profit margins than other businesses due to more significant expenses. Or other industries may tend to have higher profit margins due to having lower expenses. For example, a business consultant would likely have a high-profit margin due to low operational costs.
If the average profit margin by industry in your line of work tends to be low, that doesn’t mean you should change industries. Profit margin doesn’t measure how much money your business makes; it measures the percentage of your revenue that turns into profit.
Expansion goals
If you plan to expand, you will need to increase your profits and cash flow to fund your new business ventures. However, if you don’t currently plan to grow your company, you might be focused on maintaining a healthy profit margin rather than increasing your profit and revenue.
Size
The size of your company is also a crucial factor when determining your ideal profit margin. Smaller businesses often have larger profit margins due to having lower expenses. This doesn’t mean small enterprises make more money than larger companies. It means that a more significant portion of their revenue turns into profit. As your business grows, hiring new employees and purchasing equipment will be expenses that can reduce your profit margin if you don’t increase your sales and revenue.
Conclusion
Your profit margin is a metric that should always be on your radar, and for a good reason: it answers essential questions about your business, such as whether or not you are making money or if you are pricing your products correctly. It’s crucial to know that your margin isn’t just something you should measure; it is a metric that you should continuously improve. But, have you ever asked yourself what a good profit margin is? And as a result, how can you improve yours to make it good?
Several different factors, such as your specific industry, business size, growth goals, and the current economic situation will all dictate the definition of a good profit margin. Suppose you’re working in an industry with minimal overall costs, such as consulting. In that case, you will have a higher margin than, say, an event center that pays for facilities, inventory, and other costs. Generally, investors compare a company’s net profit margin with the net profit margin of industry competitors or a benchmark index, such as the Standard & Poor’s 500 (S&P 500) index.
As you can see, it can be tricky, both determining and understanding what’s good for your business. Therefore, do your research for your industry and track those numbers down to every last expenditure and revenue source. Knowing where you are now with your profit margin helps you determine where to go next, and it is different for each business.
