In business finance, profit margin shows you how much you make on the sale of each product or service. There are many things small business owners don’t know or forget about profit margins, including what your profit margin goals should be, to begin with. You can use our helpful guide to assess good profit margin goals for your small business.

An Overview of Profit Margin

It is one of the commonly used profitability ratios to gauge the degree to which a business activity makes money. It displays what percentage of sales has turned into profits. Put, the percentage figure indicates how many cents of profit the business has generated for each dollar of sale. To calculate margins profit margin formula is  used.

For Example

If a business reports that it achieved a 35% profit margin during the last quarter, it means that it had a net income of $0.35 for each dollar of sales generated.

There are several types of profit margin. It usually refers to net profit margin, a company’s bottom line after all other expenses, including taxes and one-off oddities, have been taken out of revenue.

Profit Margin In Business Industry

profit margin

Businesses across the globe perform for-profit economic activities with an aim to generate profits. However, absolute numbers—like $X million worth of gross sales, $Y thousand business expenses or $Z earnings—fail to provide a clear and realistic picture of a business’ profitability and performance.

Several different quantitative measures use to compute the gains (or losses) a business generates, which make it easier to assess the performance of a business over different time periods or compare it against competitors. These measures are the profit margin.

While proprietary businesses, like local shops, may compute profit margins at their own desired frequency (like weekly or fortnightly), large businesses including listed companies are required to report it in accordance with the standard reporting time-frames (like quarterly or annually). Businesses which may be running on loaned money may be required to compute and report it to the lender (like a bank) on a monthly basis as a part of standard procedures.

Some of the industries include:

  • Retail

  • Hotel and Restaurant

  • Automobile Dealership

  • Construction Supplies

  • Real Estate Development

  • Home Furnishing

  • Information Services

Why Is Profit Margin important?

Profit margins use by creditors, investors, and businesses themselves as indicators of a company’s financial health, management’s skill.  As typical profit margins vary by industry sector, care should be taken when comparing the figures for different businesses.

However, the profit margin cannot be the sole decider for comparison as each business has its own distinct operations. All businesses with low-profit margins like retail and transportation will have high turnaround and revenue which makes up for overall high profits despite the relatively low-profit margin figure.

High-end luxury goods have low sales, but high profits per unit make up for high-profit margins.

Technology companies like Microsoft and Alphabet have high double-digit quarterly profit margins compared to the single-digit margins achieved by Walmart and Target. However, it does not mean Walmart and Target did not generate profits or were less successful businesses compared to Microsoft and Alphabet.

Formula To Calculate Profit Margin

You can calculate the profit margin with the help of the following mathematical formula:

Profit Margin = Net Profits (or Income) / Net Sales (or Revenue) x 100

Or,

Profit Margin = Net Profits (or Income) / Net Sales (or Revenue)

= (Net Sales – Expenses) / Net Sales

= 1- (Expenses / Net Sales)

Thus, net income is the total revenue minus business expenses. Net sales are gross sales minus discounts, returns, and allowances. Dividends paid out are not considered an expense and are not considered in the profit margin formula.

Taking a simple example

If a business realized net sales worth $100,000 in the previous quarter and spent a total of $80,000 towards various expenses, then from the above profit margin formula, we can calculate profit margin as given below:

Profit Margin = 1 – ($80,000 / $100,000)

= 1- 0.8

= 0.2 or 20%

It shows the business managed to generate profits worth 20 cents for every dollar worth of sales.

The profit margin improves by increasing sales and reducing costs. Theoretically, higher sales can be achieved by either increasing the prices or increasing the volume of units sold or both.

A price rise is possible only to the extent of not losing the competitive edge in the marketplace, while sale volumes remain dependent on market dynamics like overall demand, percentage of market share commanded by the business and competitors’ existing position and future moves.

Similarly, the scope for cost controls has also its limits. One may reduce or eliminate a non-profitable product line to curtail expenses, but the business will also lose out on the corresponding sales.

It becomes a fine balancing act for the business operators to adjust pricing, volume and cost controls. Profit margin acts as an indicator of business owners’ or management’s adeptness in implementing pricing strategies that lead to higher sales and inefficiently controlling the various costs to keep them minimal.

What Makes A Good Profit Margin For Your Small Business?

From a billion-dollar publicly listed company to an average Tom’s side-walk hot dog stand, the profit margin figure is widely used and quoted by all kinds of businesses across the globe. It is also used to indicate the profitability potential of larger sectors and of overall national or regional markets.

Profit margin has become the globally adopted standard measure of the profit-generating capacity of a business. And it is a top-level indicator of its potential.

Internally, business owners, company management and external consultants use it for addressing operational issues and to study seasonal patterns and corporate performance during different time-frames. A negative profit margin translates to a business either struggling to manage its expenses or failing to achieve good sales.

A further drill-down helps identify the leaking areas —

Like high unsold inventory, excess yet under-utilized employees and resources, or high rentals and then devise appropriate action plans. Enterprises operating multiple business divisions, product lines, stores or geographically spread-out facilities may use profit margin for assessing the performance of each such unit and compare it against one another.

Profit margins often come into play when a company seeks funding. Individual businesses, like a local retail store, may need to provide it for seeking (or restructuring) loan from banks and other lenders. It also becomes important while taking out a loan against business as collateral.

Large corporations issuing debt to raise money is important to reveal their intended use of collected capital and that provides insights to investors about profit margin that can be achieved either by cost-cutting or by increasing sales or a combination of both. The number has become an integral part of equity valuations in the primary market for initial public offerings (IPO).

Finally, profit margins are a significant consideration for investors. Investors looking at funding a particular startup may like to assess the profit margin of the potential product/service being developed. While comparing two or more ventures or stocks to identify the better one. Investors often hone in on the respective profit margins.

Improve Your Profit Margin With These Tips

Understanding your profit margin is the first step in improving your margins. Once you have that data, these are just a few ways you can help your business improve its profit margin:

(a) Reduce expenses 

Knowing your profit margin can help uncover bloated spending practices or help you make decisions about where to cut costs. It is all about keeping your overhead as low as possible, while able to produce a quality business product.

(b) Cut under-performing products or services 

Perhaps your gross profit margin determines that one of your products manufactures at a higher cost, but is not selling as well as other products on the market. Making that call is only yours to make, but it is certainly one way to bring up your profit margin percentage if that is indeed the goal.

(c) Increase product offerings or services 

Could your business be doing more while maintaining equivalent overhead expenses? If so, this means more money in your pocket. Consider going the extra mile with what you already have. And if you don’t need to make huge financial investments in order to accomplish that, then it might be time to just go for it.

Remember, your best customer is often the customer you have already won, so consider increasing product offerings or level of services to your most loyal customers to get more out of them.

(d) Increase pricing

Increasing prices can be a difficult decision for small businesses that are competing with larger companies, but sometimes it is necessary for your business’ long-term survival. However, make sure that you are not overcharging, but you also want to ensure that you are not undercutting yourself at very low prices.

Conclusion

Profit margins can be tricky, both in terms of determining them and understanding what is right for your business. Research for your industry and make sure to track those numbers down to every last expenditure and revenue source. Knowing your margin helps you determine where to go next and it is different for every business.

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