For all aspiring business owners, knowledge about what is a net profit margin and how to calculate it properly is a must-have tool for operating a sustainable and profitable company in the long run.
Key Takeaways
- The net profit margin is the amount of money that stays in the company bank account from gross sales after all business operational expenses (including tax) are paid.
- The difference between profit and net margin is that this second metric includes tax-related expenses.
- To calculate a business’s net profit margin properly, the smallest expenses must be put into the accounting and deducted from gross revenue.
- A 20% margin for independent businesses and a 10% margin for franchised businesses is considered good business result.
- Companies can improve their net profit margins by hiring freelancers and interns and thus save money for labor expenses that usually produce 30% of all operational costs.
What is Net Profit Margin?
Net profit margin is a ratio of how much money stays in a company bank account after all business operating expenses, including tax, are deducted from gross revenue. It can be represented as a percentage or as a decimal.
This profit metric refers to a company’s returns in cents for every dollar of sales it makes.
Unlike profit margin, this metric includes all expenses and income streams of the entire company, and it represents the most accurate way to determine overall business profitability.
Profit Margin vs. Net Profit Margin
Profit margins are earnings that stay in the company after deducting operational expenses before tax. Net margin is referred to as one calculation that includes tax-related expenses.
Both of these profit metrics are often used by companies, and that is since each state has its regulations regarding business tax percentages!
Often businesses that are operating in more than one state first calculate profit margin and then later apply tax according to the location where owners will run their business operation.
How to Calculate Net Profit Margin
To calculate these margins correctly, we must expose all our business financial data to extract metrics that are important for this calculation.
Include these metrics in the net profit margin calculation:
Total Revenue/Gross Sales
This term is referred to the total amount of money a company earns by providing services and selling goods.
This is the most important data when calculating the overall profit ratio because it represents all money a business generates from selling its services/products.
Operating costs
This metric includes all payments spent to run a business. Rent costs, employee payroll, travel expenses, utilities, insurance, maintenance and repair of facilities, taxes, office supplies, advertising expenses, etc., must be included in this calculation.
Interest expenses and debt obligations
Most businesses have interest expenses and debt to pay back. These are considered liabilities and must be included when calculating a company’s margins.
Investment income/ secondary operation income
The investment income of a business is money that the business earns from renting out a property it owns, interests from debts it has provided, royalties, etc. Secondary operations revenue refers to revenue produced by a company through processes that aren’t the principal activity/operation of the company.
Unusual one-time payments
These include payments like lawsuit expenses. These can consist of taxes as well.
The Formula For Calculating Net Profit Margin
Net profit = Revenue – Cost of goods – Operating expenses – Interests – Taxes
Net profit margin = Net Profit / Revenue * 100
Example 1
An apparel company makes $3 Million in a year. The company spends $1.2 Million in operational costs and costs of goods and $0.5 Million in taxes and interests.
Here’s how the company’s net profit margin is calculated for that year as a percentage:
= ($3 Million – $1.2 Million – $0.5 Million) / ($3 Million) * 100
= 43.3%
The apparel company has made a profit of $0.43 for every dollar it made in gross revenue.
Example 2
A business that provides transportation services makes $300,000 in revenue in a quarter. The company spends $225,000 on operating costs and $30,000 on interests and taxes.
Here’s how the company’s net profit margin is calculated for that quarter:
= ($300,000 – $225,000 – $30,000) / ($300,000) *100
= 15%
The transportation service-providing company has made 15 cents for every dollar it earns in revenue.
Limitations of Net Profit Margin
This metric doesn’t always accurately reflect the success of a company since this metric differs from industry to industry.
Industries like the automotive industry can have a very high net profit margin but lower revenue compared to the agricultural sector, which has a lower margin but higher revenue.
It’s best to use several metrics when analyzing the strengths and weaknesses of a company.
This metric can be heavily influenced by one-time financial endeavors, like selling a large-scale asset of the company or buying a new property.
What is a Good Net Profit Margin
The good net profit margin for independent businesses is one that is at least 20%, and for franchised businesses is one that exceeds at least 10% of all the gross sales that the company/business generates.
Independent businesses in the same sector as franchised ones usually have a lower sales volume, so they need to have higher margins in order for the owner to make decent money from its operations.
Franchised businesses, due to the fact they are part of well-known brands, benefit from higher gross sales. However, they pay royalties to the franchisor, usually 10% of all sales, so 10% of the margin is considered as good for this industry.
Why is Net Profit Margin Important
This metric can show prospective investors the potential net worth of the company. In a competitive market, having a consistently high net profit margin will catch the eyes of potential investors, even if you’re a new business.
This metric is a great way to showcase the profitability potential of a company.
Companies’ CEOs can make important financial decisions based on the net profit margin. If it’s too low, they can consider cutting costs to make it higher to appear more attractive to prospective investors.
How to Improve a Company’s Net Profit Margin
The factors that reduce the net profit margin are operational expenses, taxes, debt obligations, and additional secondary income streams. But, it is possible to improve overall business profitability by implementing good practices in business.
Automate time-consuming tasks
Some tasks that companies can automate to save money and time are customer support and data collection, invoice creation, recurring bill payment, proofreading, e-mail marketing, and computer backups.
The time-consuming tasks can be automated through chatbots and special applications.
Hire freelancers
Companies can outsource marketing, designing, and content writing tasks to a freelancer.
Freelancers are cost-efficient. Since they’re not employees, the company doesn’t have to worry about costs like health insurance, overtime pay, and employee benefits.
Companies can also hire freelancers seasonally as the company requires, eliminating the need to pay an employee year-round.
Integrate internships
Incorporating interns into a company can help the company save money in several ways.
Interns are individuals the company provides training depending on the value of the training the company offers. The interns can even be unpaid. After the internship ends, interns that were valuable to the company can be employed directly.
This practice can help save costs related to interviewing and selecting candidates for employment.
Go paperless
Going paperless is easier today than ever. With everyone switching to cloud-based applications to store data, it’s easier to cut costs because the cost of sharing documents and editing them is significantly lesser.
If you go entirely paperless, the company will reduce the costs associated with stationery supplies like pens, paper, envelopes, and staplers.
Implement a bidding system for vendors
Entertaining different vendors on their offers for services the company needs. This will help keep the company aware of the latest deals and allow the company to try out other vendors to choose which is best in the long run.
Pay bills in advance
Some vendors provide discounts for companies that pay their fees in advance. The discounts are usually 2-3%, but these can add up as profit with each billing cycle.
In the least, a company should pay the bills on time to avoid late payment fees. However, to be able to implement this practice, the company must have good financial health and necessary working capital.
Downsize wasteful habits
Encouraging a company’s employees to reduce the unnecessary use of electronics can help reduce the electricity bill.
Switching to low-power electronics such as LED lights instead of filament bulbs can be a worthwhile investment in the long run.
Summary
It is pretty simple to make a calculation regarding net profit margin if the company owner tracks all the expenses associated with running its business. So it is highly advisable to use tools that can help with tracking financial aspects of everyday business operations.