July 20th, 2021 by Suzanne Robertson
Wondering how to calculate your small business profit margin and how it can apply to your finances? Look no further: were breaking down the metric so you can better understand your companys financial health.
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What is a Profit Margin?
A companys 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 businesss 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 companys 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 Businesss Profit Margin
Among the variables that can affect your companys 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 youre 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 cant currently access. Put another way, the less stock you have on your shelves for sale, the less money youve 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 dont pay taxes, they may sometimes have higher profit margins than corporations (even if corporations are often profitable).
- Location . Your companys 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 companys 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. Heres 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 : Youll most likely use this calculation to judge how profitable your business is overall. Take your companys 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 Universitys 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, Whats 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, theres 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 wont tell you much.
- Industry averages : With data like NYUs Margins by Sector, you can see how your company stacks up against the industry benchmark. Dont forget to take your geographic area into account too.
- Business growth : A healthy profit margin will also depend on your expansion goals. When youre 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 youre losing to costs, wouldnt lowering your costs quickly boost your profit margin? The answer, of course, is yes.
- Dont 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 dont have enough stock available to meet consumer demand, it wont take long for unrealized revenue to capsize your profit margins. Conversely, if you have more stock on hand than needed to meet demand, youll be stuck with excess inventory that you cant sell. The result is sunk costs that you cant 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 youll 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 businesss 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.
Get started with SmartBiz Advisor today to receive personalized insights and recommendations on your small business. This free, online, AI-based tool is based on our lending partners key criteria and can help you learn more about qualifying for the low-cost funding you deserve.
* The information provided through SmartBiz Advisor, including the Loan Ready Score, is for educational purposes and is not the same as scores used by lenders for credit decisions. SmartBiz Advisor is not a financial or legal advisor as defined under federal or state law. Use of this information is not a replacement for personal, professional advice or assistance regarding your finances or credit history.
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