The business is all about making money. So all aspiring entrepreneurs must learn what is a profit margin and how to increase this earning parameter so that more money stays in the business owner’s pocket.
- The profit margin is a ratio that shows how much a company has earned after all expenses (except tax) are deducted from gross sales the business has generated in a given period.
- The profit margin formula for calculating it is “Gross Sales – Operating Expenses = Profit Margin.”
- It is better if the business owners decide to calculate Net Profit Margin because this calculation includes all operating expenses + tax costs.
- Reducing operating costs to a minimum possible will help in the process of making higher margins from the same level of sales.
What Is a Profit Margin?
The profit margin is a ratio that represents the percentage of sales that has turned into the company/owner’s earnings. This business term refers to the number of dollars that stays in the company after all production expenses are deducted, except taxes.
It can be calculated monthly, quarterly, or on a yearly basis. If a business makes a 40% margin per year, the profit earned per dollar in sales is 40 cents.
There are several varieties of profit margins, but the most important type is the ‘net profit margin,’ which factors in all operating costs, including taxes, etc.
The margins are industry-dependent. Some industries can deliver high, but also we have ones that are considered low-profit margins industries.
High-profit margin industries include businesses that sell luxury items. These types of businesses have high gross sales revenues and low sales volumes. The items, like luxury cars or luxury clothing, are often made to order, and that reduces unnecessary operating costs.
Usually, businesses that experience a lack of competition in their market can sell their services/products for higher profit!
Low-profit margin industries often have high sales and high inventory. Such as agricultural businesses, transportation services, and fast fashion brands.
These industries are resource intensive and face uncertainties like weather and storage challenges, making them not as much profitable as are one’s industries that have the better market condition.
How to Calculate Profit Margin
Gross Sales – Operating Expenses = Profit Margin.
We can present this business earning parameter as a fraction or as a percentage. If, for example, the margin is 20 cents per dollar, it can be represented as 20% or 0.2.
A high-end sports gear company makes $500,000 in gross revenue and has $20,000 in expenses.
The math would work out as follows:
- ($500,000 – $200,000) / $500,000 = 0.6
The margin is 60 cents per dollar, 0.6 or 60%.
An organic vegetable distribution company makes $5 Million in sales and bears $3.4 Million in expenses.
The profit margin of this company is calculated as follows:
- ($5 Million – $3.4 Million) / $5 Million = 0.32
The distribution company’s earnings are 32 cents per dollar, 0.32 or 32% of the margin.
A cosmetics company makes $20,000 in sales and has $14,000 in expenses.
This is how we calculate the margin for this cosmetic company:
- ($20,000 – $14,000) / $20,000 = 0.3
The company has made 30 cents in profit per dollar made in sales.
Why the Profit Margin Is So Important in Business
All businesses, large and small, use this universal metric, from international luxury brands to street food stalls. And that is due to the fact it’s a good indicator of the potential of a business.
Managers can use the average profit margin of an industry to measure the reaction an industry has to different economic signs of progress and regressions.
The company’s Financial Executive Officer can make important decisions based on thearning parameters. If it is negative or too low, that could indicate that the company has too many expenses or isn’t making enough sales, and that will be reflected in the available working capital in the long run.
By knowing the overall profitability of the business, companies can use strategies to increase their sales or reduce their expenses.
Profit margins can also be used to track seasonal patterns, and this data can be utilized to create future strategies.
Knowing your business margins when applying for a loan from a bank or a lender. Businesses with the potential to make high earnings in the future will easily get support from third-party finance sources.
In addition, this metric is necessary to attract investors, as it’s a great way to show the investors the potential of the business. Investors typically look at multiple similar businesses and have a higher chance of winning the investor if the company has a higher profitability potential.
Types Of Profit Margin
Gross Profit Margin
This parameter helps a company figure out its rawest profit margin. It only refers to the amount of money earned from sales and the cost of creating those sales. The expenses related to sales typically include costs of raw materials, labor, etc.
GPM = (Sales – Cost of goods sold) / Sales
Operating Profit Margin
They are operating profit margin concerns for costs of goods sold, operating costs, and general and administrative costs. The resulting income gives the company an idea of the wealth they have in hand to pay back loans taken from banks or lenders, pay taxes, etc.
OPM = Operating income / Revenue
Pretax Profit Margin
PPM = (Operating income + interest income – interest expenses- losses)
Net Profit Margin
When people speak of a company’s profit margin, they usually refer to this. It’s calculated by dividing net profit by net sales for a given period of time.
Net profit margin is calculated by considering all business expenses, including operational expenses, taxes, cost of materials, cost of labor, and other expenses.
NPM = (Net profit) / (Net sales)
How to Improve the Profit Margin of a Business
Manage your inventory better
Have a thorough knowledge of your inventory. Pay attention to what’s selling, what products are challenging to sell, and other related information.
This way, you can avoid unnecessary markdowns. Those are great at killing business profit. Using a thorough marketing knowledge, you must create marketing and sales strategies. This will lead to better sales and a lesser need for markdowns.
Increase the perceived value of your brand
This can be done in many ways, including creating a personal connection with your customers. By changing the packaging and appearance of your product, you can convince customers your brand is high-end and will give them a good experience.
Marketing and advertising play an essential role here!
Reduce operational expenses
Operational expenses are diverse, so you can make various decisions to curb them.
Here are some suggestions:
- Cut overtime and excess staffing as much as possible.
- Automate specific tasks in the business.
- Start using less expensive supplies.
Increase the business’s average order value
Another great way to increase the margins of a business is by increasing a sale’s basket value or average order value. This can be done by strategic product placement, offering discounts for orders above a specific value, putting high-profit items in high-traffic places on your website, and promoting impulse purchases.
Knowing what is and how to calculate your business profit margin will take a big role in your overall business success!
Often the investors are guided by the gross sales that particular industry can deliver. However, it is a much more important parameter to know how much is possible to extract money after all operational expenses are deducted.