Profit Margin
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“There is no such thing as a good business with a bad profit margin.”
I suppose many of you have already heard this famous line by Jack Welch, the former CEO of General Electric.
But what exactly is profit margin?
– How does it even correlate with the nature of business?
– And most importantly how can you calculate it of your business easily?
Hold on.
At least for a couple of more paragraphs until I explain all your questions + more questions regarding profit margin comprehensively.
So, let’s get started with your 1st question.
What exactly is profit margin?
Profit margin, often referred to as ‘margin’, is a measure of how much money a business makes from its sales, after deducting all the costs and expenses. It’s a great determinant of efficiency and profitability of a business. It is usually expressed as a percentage of the revenue, which is the total amount of money received from selling goods or services.
Example
if a business makes a revenue of $100,000 that includes a profit of $20,000, then its profit margin,
= ( $20,000 / $100,000 x 100% ) i.e., 20%
This suggests that for every $1 of revenue, the business earns $0.2 of profit.
A higher profit margin suggests that the business is efficient and profitable. While a lower profit margin indicates that the business is not commercially viable in the long run, as it might not be able to generate enough profit to sustain itself or grow.
Now to the next question.
Why should you even bother about profit margin?
Here are some few good reasons for why profit margin is important for a business:
1. It measures operational efficiency of your business.
Profit margins indicates the operating efficiency and growth potential of a business.
Businesses with a high profit margins typically excel at organizing, controlling and utilizing its resources. Be it human resource, plant and machinery or managing the supply chain – they optimize it effectively ensuring minimal waste of resources. Also, these businesses possess growth potential, meaning that they have the ability to sustainably increase their revenue and profit in the future.
2. It measures the utilization of per dollar of revenue that you make.
Profit margins helps a business account how much money they are left after paying off all the business expenses and costs.
3. Profit margins helps set effective pricing strategies.
Understanding profit margins help businesses determine the minimum price they need to charge to the customers to cover costs and generate a desired level of profit.
4. A profit margin is often liked to financial stability of a business.
It is essential for a business’s health and its ability to generate cash flow, ultimately leads to keep a business financially stable and sound.
3. It helps you compare your business performance against the industry.
Profit margin is used to compare the performance of a business with its competitors and with the industry at large.
For example, if a business has a profit margin of 10%, it might seem good. But if the average profit margin of its industry is 15%, then we may conclude that the business is not performing well compared to its competitors from that same industry.
What are the types of profit margin?
Based on the operational efficiency, profit margin can be of 4 different types –
1. Gross Profit Margin
Gross profit margin is a financial ratio that shows how much of a business’s revenue is left after deducting the cost of goods sold (COGS).
COGS is the total expense a business makes to manufacture an item for sale which typically include labour cost, cost of raw materials or any other directly production associated costs.
BTW, when we refer to profit margin, it generally means Gross profit margin.
Formula: Gross profit margin = (Net Sales – COGS) / Net Sales x 100
2. Net Profit Margin
Gross profit margin is not the only measure of profitability of a business. Net profit margin is another financial ratio that shows how much money a business makes after deducting COGS and other core operational expenses such as taxes, debts etc.
Net profit margin is a more comprehensive measure of profitability than gross profit margin, because it shows how much of each dollar of sales a company keeps as net profit, after paying for all the costs.
So, it effectively suggests how much money as a business owner you get to take home every month.
Formula: Net profit margin = (Revenue – COGS – Operating expenses – Interest – Tax) / Revenue x 100
3. Operating Profit Margin
Operating profit margin indicates how much money a business makes from its core activities such as selling products or services after paying off all the costs related to production and operation of the business. It includes indirect expenses such as depreciation and amortization.
Formula: Operating Profit Margin = Operating Profit / Total Revenue x 100
Where,
[Operating profit = Revenue – COGS – Operating expense – Depreciation and amortization]
What is considered a good profit margin? (+ industry benchmarks)
The answer to the question “what is a good profit margin?” depends on various factors, such as the industry, the business model, the age of the business, and the growth goals.
Different industries have different average profit margins, depending on the level of competition, the demand and supply, the pricing strategy, and the cost structure. For example, software companies tend to have higher profit margins than grocery stores, because they have lower COGS and higher prices.
Similarly, different business models have different profit margins, depending on the revenue streams, the customer acquisition costs, the customer retention rates, and the customer lifetime value.
Therefore, a good profit margin for a business has to be –
- higher than the industry average, the business model benchmark, and the business stage expectation.
- consistent or increasing over time, indicating that the business is able to maintain or improve its profitability and efficiency.
For your quick reference, check out industry benchmark of US-based companies and their average gross profit margin and net margin till March 2024. It will give you a holistic look through on numbers.
How to calculate profit margin effectively?
To calculate profit margin effectively, there are different accounting softwares in the market. However, to keep it basic, hands-on and easy to all, I will show you how to calculate profit margin using a spreadsheet.
You may use either Microsoft Excel or Google sheets to follow this calculation process showed below.
In the below screenshot, you can see I have added a fictitious company’s financial data from the last three years to give you a detailed reporting and analysis of different profit margins for comparison on YoY basis.
I have deducted COGS from the sales revenue made during these 3 years to find out Gross profit. Then divided the gross profit by sales revenue to collect Gross profit margin. After that, you have deducted all business operational expenses from that Gross profit margin to come at operating profit and margin.
In the final step, I have deducted non-operational expenses such as loan interest, current taxes etc. from the operating profit to figure out the net profit and net profit margin. This is the amount the business is left with at bank and the owners can take away to their homes.
Also, checkout the trends in the net profit, it has increased YoY basis which is a positive sign for any business. It suggests that our business is growing.
Tools for profit margin analysis
Apart from the traditional spreadsheet, you can use specialized softwares and tools to help you with the process of processing,reporting and analyzing profit margins efficiently.
In this case, there are 2 types of tools that are used in the market, viz., accounting software and financial analysis tools.
1. Accounting software
Accounting softwares help you record, track, and manage your financial transactions, such as sales, expenses, invoices, payments, taxes, etc. It automates the calculation of revenue, cost of goods sold, operating expenses, and other financial metrics, and generates financial reports that show you the performance and health of your business.
For businesses seeking comprehensive solutions tailored to their financial needs, exploring financial software solutions can streamline operations and enhance financial management efficiency.
It also allows you to create budgets, forecasts, and scenarios, and integrates with other tools and platforms.
QuickBooks, FreshBooks, Xero etc. are some of the most used accounting softwares.
2. Financial analysis tool
Financial analysis tools are software that help you analyze, visualize, and communicate your financial data, such as revenue, expenses, profit margins, cash flow, etc.
They allow you to create and customize financial models, such as profit and loss statements, break-even analysis, sensitivity analysis, etc., and create and display charts, graphs, tables, and dashboards.
They also help you perform various calculations, such as ratios, percentages, averages, etc., and access and import data from various sources, such as accounting software, spreadsheets, databases, etc.
Some examples of popular financial analysis tools are Microsoft Excel, Tableau, Power Bi etc.
What are some factors that affect the profit margin of a business?
Profit margin of any business is influenced by various factors, both internal and external, that affect the revenue, the costs, or both. Here are some common factors :
Cost of goods sold (COGS)
COGS affects the gross profit margin, which is the revenue minus the COGS. If the production cost is too high, it cuts a chunk from the gross profit resulting in a lower profit margin.
Pricing strategy
Pricing strategy directly impacts the sales revenue, which is the numerator of the profit margin formula. Pricing of a product/service impacts the demand and the market share of it, which can have a positive or negative impact on the profit margin.
Operating expenses (OPEX)
These are indirect expenses to run the business operations, such as salaries and benefits, rent and related overhead expenses etc. OPEX affects the operating profit margin, which is the revenue minus the COGS and the OPEX. A lower OPEX means a higher operating profit margin, and vice versa.
Economic factors
There are other external factors that affect the general economic conditions of a nation, such as high inflation, interest rates hike, wars etc. These externalities affect both the revenue and the costs of a business impacting profit margins and overall profitability of a business.
Industry competition
High Industry competition impacts pricing strategy, market share etc. of rival businesses. Under such conditions, once a business increases or decreases its product pricing, the rival company does the same to catch market share. Coke and Pepsi are the most popular examples of this phenomenon. This kind of cut-throat impacts the bottom line (a.k.a ‘Net profit’) of the business.
How to improve the profit margin of a business?
Fundamentally, there are two ways a business can improve its profit margin either by cutting down its expenses or by increasing its revenue from sales. However, In practice, businesses try to optimize both ways to strike a sustainable balance.
Here are some ways you can improve the profit margin of your business –
1. Streamline business processes
Streamlining several business processes using a mix of tech and manpower can help you simplify, optimize, and automate the tasks and workflows involved in the day to day business operations. This usually reduces operating costs and increases the efficiency of the business operations, which can lead to higher profit margins.
For example, B2B SaaS businesses can automate their outbound sales process using a sales engagement platform like SmartReach. This automates the entire sales outreach process using multichannel such as Email, LinkedIn, Whatsapp, Calling and text messages. Also, they automate the reporting process as well.
2. Raise pricing reasonably
This is the simplest and most direct way to increase sales revenue. It means that there will be more cash inflows to the business with each sale.. However, this strategy also has some inherent risks, such as losing customers, reducing demand, or attracting more competition. So, carefully consider the value and quality of your product or service, the price elasticity of demand, and the competitive landscape before raising the price of your product or service.
3. Increase customer retention and satisfaction
This is especially important for service based businesses, as frequent customer churn is a serious problem to these businesses. Increasing customer satisfaction and retention is linked to higher customer lifetime value( CLV) and higher positive NPS (net promoter score). Customer satisfaction creates a referral effect and brand loyalty among the customers. All these in combination contribute to repeated purchases, subscription, plan updates etc. which help improve the profit margin of a business.
4. Cut down low-performing products
This practice comes handy if you own physical inventory and it’s a very common practice in the FMCG industry. Stop producing and marketing your low-performing products in the market because these unsellable products slog the inventory blocking your gross profit. Cutting down and low-performing products and prioritizing high-performing products can help you achieve higher profit margins.
FInal thoughts
Profit margin is one of the key indicators of a company’s profitability and performance. It measures how much from each dollar of sales a company can retain as earnings after paying off all its expenses.
Profit margins can vary depending on the industry, business model, and competitive environment. They can be optimized by using a number of quantitative and qualitative measures that I have spoken about in the above section.
By understanding how to calculate profit margin and draw insights you can gain valuable insights into your business’s strengths and weaknesses, and identify areas for improvement and optimization.