Wondering how to calculate your small business profit margin and how it can apply to your finances? Look no further: we’re breaking down the metric so you can better understand your company’s financial health.
What is a Profit Margin?
A company’s operating profit margin, also referred to as its return on sales, measures the proportion of income to revenue. This number reveals how much profit your business is generating from sales, and can help you set goals and gauge your progress. Plus, lenders like SmartBiz may require you to present your business’s profit margin to get a sense of its financial health.
What Your Profit Margin Says About Your Business
Your profit margin tells you how much of your total revenue your company is earning. As such, your profit margin value is a clear reflection of your bottom line. With this one number, you can quickly estimate your company’s net income based on the total sales you make in a given period. This calculation makes your financial forecasting significantly easier.
Variables That Affect a Small Business’s Profit Margin
Among the variables that can affect your company’s profit margin are the following:
- Labor costs . As a key factor in your cost of goods sold (COGS), labor costs strongly affect how much of your revenue you keep as profit. The less you’re spending to produce what you sell, the less money from your sales that goes toward covering your costs. The result is higher profit margins.
- Inventory . When you have stock sitting unsold in your warehouse, the sale price of these items is potential future income that your company can’t currently access. Put another way, the less stock you have on your shelves for sale, the less money you’ve spent acquiring inventory that you convert to profit. Additionally, inventory management software can be an expensive business cost that reduces your profits.
- Taxes and regulations . If your company is a corporation, it will pay 21% of its revenue as taxes. If your company is instead a sole proprietorship or partnership, its income will pass through to its owners as personal income and be taxed accordingly. Since non-corporations technically don’t pay taxes, they may sometimes have higher profit margins than corporations (even if corporations are often profitable).
- Location . Your company’s tax obligations may vary based on its location, as most but not all states charge additional business taxes. If your business is located somewhere with no state-level corporate taxes, your company will have a higher profit margin as compared to its out-of-state competitors. Additionally, since renting or buying commercial real estate may be more expensive in major metropolitan business hubs, companies based in cities may have different profit margins than businesses in other locations.
- Use of assets . Smart use of assets can increase your company’s return on investment (ROI) and thus improve your profit margin. The more revenue dollars to which your asset use leads, the higher your profit margin.
- Equipment maintenance . Your equipment is among your key assets, and outdated or failing equipment prevents you from offering the most products or services possible. That said, upgrading your equipment often costs enough money that temporarily smaller profit margins could result. However, in the long run, better equipment often leads to more productivity and thus higher profit margins.
- Cost control systems . Even if the term “cost control systems” sounds unfamiliar to you, chances are that your company has them. They include any and all budgeting processes, as any approach to identifying and lowering your operating costs is a cost control system. Properly using such systems can increase your profit margins.
How to Calculate It
There are two main types of profit margins small business owners can use to calculate: gross profit margin and net profit margin. Here’s how they break down:
- Gross profit margin : This measurement is used to determine the profitability of a certain product, not of the entire business operations. So if it costs you $40 to make a single product but you sell it for $50, your gross profit margin will be $10 divided by $50, which is 20%.
- Net profit margin : You’ll most likely use this calculation to judge how profitable your business is overall. Take your company’s total sales for a specific time period, subtract your total expenses, and then divide that number by your total revenue. So if your business made $500,000 last year and had expenses of $350,000, your net profit margin would be ($500,000-$350,000)/$500,000 = 0.30, or 30%.
The Profit Margin Formula
Each of the above types of profit margin has its own formula into which you can quickly plug numbers from your financial statements. Doing so through an Excel sheet can make it especially quick to calculate your profit margin.
The gross profit margin formula is:
Gross profit margin = (Net sales - COGS)/Net sales
The net profit margin formula is:
Net profit margin = (Revenue - COGS - Operating costs - Other expenses - Interest - Taxes)/Revenue
or, more simply,
Net profit margin = Net income/Revenue
Seeing these formulas written out may make it clearer that net margins account for far more real-life business expenses than do gross margins. As such, you may want to use solely net margins for your profit margin calculations.
What Is the Average Profit Margin for a Small Business?
Average profit margins vary considerably by industry. Below are some industries and their average margins as of January 2021, as compiled by New York University’s Margins by Sector report:
- Brokerage and investment banking: 60.83% gross profit margin and 12.71% net profit margin
- Computer services: 27.16% gross profit margin and 3.62% net profit margin
- Construction/engineering: 14.09% gross profit margin and 0.75% net profit margin
- Electronics: 26.53% gross profit margin and 3.49% net profit margin
- Farming and agriculture: 14.14% gross profit margin and 3.81% net profit margin
- Food wholesale: 15.49% gross profit margin and -0.36% net profit margin
- Food retail: 26.25% gross profit margin and 2.20% net profit margin
- General retail: 24.27% gross profit margin and 2.79% net profit margin
- Insurance: 30.71% gross profit margin and 1.43% net profit margin
- Office and equipment services: 35.26% gross profit margin and 1.95% net profit margin
- Online retail: 42.53% gross profit margin and 4.95% net profit margin
- Restaurants: 27.60% gross profit margin and 5.69% net profit margin
The above numbers may give you the best answer to the question, “What’s a good profit margin?” However, these statistics on their own may not provide perfect frames of reference.
Good Profit Margins
When it comes to ideal profit margins, there’s no single number to look for. Unless you include your industry, your expansion goals, and your unique business situation, comparing your profit margins to other businesses’ won’t tell you much.
- Industry averages : With data like NYU’s Margins by Sector, you can see how your company stacks up against the industry benchmark. Don’t forget to take your geographic area into account too.
- Business growth : A healthy profit margin will also depend on your expansion goals. When you’re looking to make a large purchase, you might want your profit margins to be slightly higher so you can budget for the future.
- Business age and size : As a rule of thumb, newer businesses usually have higher profit margins because of lower overhead costs. As operations grow, profit margins might come down.
Tips for Improving Your Profit Margin
To improve your profit margin, take the below steps:
- Cut costs . Perhaps the fastest way -- and most obvious way -- to improve your profit margin is to cut costs. If profit margins represent how much of your revenue you’re losing to costs, wouldn’t lowering your costs quickly boost your profit margin? The answer, of course, is yes.
- Don’t just sell more – sell the right products or services . Selling more items means more revenue, but if you sell more items without figuring out how to reduce your production costs, your profit margins will only change slightly. For quicker profit margin increases, determine which of your items have the lowest profit margins. Then, figure out how to cut costs for these items or entirely stop selling these items. If you stop selling these items, then produce more of your higher-margin items.
- Keep the right amount of stock on hand . If you don’t have enough stock available to meet consumer demand, it won’t take long for unrealized revenue to capsize your profit margins. Conversely, if you have more stock on hand than needed to meet demand, you’ll be stuck with excess inventory that you can’t sell. The result is sunk costs that you can’t convert to revenue and thus lower profit margins.
- Speak with your suppliers . Suppliers are often willing to renegotiate their deals with small business owners. Ask your suppliers whether they can lower their rates for your account or add provisions through which you’ll receive early payment discounts. If your supplier implements these changes, your operating costs will be lower and your profit margins will be higher.
How To Improve Your Profit Margin
Once you know where you stand, you may want to look into improving your profit margin year over year. Some areas to consider are operating expenses and sales. If you find certain products are too costly to maintain or find opportunities to boost incoming revenue, make sure to act on those chances at growth.
Understanding your business’s profit margin takes paying attention to your individual situation. With the right tools, you can use the number to discover areas for growth and expansion.
