Your company's profit margin is the amount of revenue you have left over after paying operational expenses. Businesses in all industries of all sizes use this number as a primary measure of financial solidity.
We've developed this comprehensive guide to help you set a profit margin that makes sense for your small business.
What Is a Profit Margin?
Profit margin shows the earnings your company keeps after the cost of doing business. For example, a profit margin of 10% means you spend 90 cents of every dollar your company earns on expenses and retain the other 10 cents.
Higher profit margin translates to a stronger, healthier business, while lower profit margin indicates the need to make changes. The exact number that separates good from poor profit margin varies significantly by industry, so it's important to evaluate competitors in the same sector when setting objectives.
What Are the Different Types of Profit Margin and How Are They Calculated?
Business owners should become familiar with these common types of profit margin.
Gross Profit Margin
You can use gross profit margin to find the profitability of one item or a category of products. To find this number, subtract the cost of goods sold (COGS) from your revenue for a specific time period. Then, divide the result by the revenue and multiply by 100 to change the decimal to a percentage.
COGS includes any expenses that pay for products you sell. It covers items like manufacturing overhead, payroll and raw materials.
If you have a low gross profit margin in a certain area of your business, your COGS for that item could be too high. Looking for ways to cut these expenses will boost profitability. You can also track changes in gross profit margins to see how changes in areas such as management or process affect your company's financial health.
Operating Profit Margin
To go a bit deeper with this metric and improve its precision, you can calculate the operating profit margin. Subtract both operating expenses and COGS from revenue, then divide by revenue and multiply by 100.
For the purposes of this calculation, the term ‘operating expenses’ covers costs beyond COGS. Examples of expenses in this category include accounting and inventory software, marketing costs, payroll, and rent or mortgage for your business location. However, you don't include taxes or interest paid toward debt.
Net Profit Margin
Net profit margin provides a more accurate picture of the company's overall profits than gross profit does. It appears at the bottom line of your company's income statement, which highlights profits over time.
To find this metric, you'll subtract your business expenses from total sales for a specific time period (month, quarter, or year, for example). Then, divide the result by the revenue for the period in question to reach net profit margin.
This calculation provides the most comprehensive measure of profit margin. Net profit margin removes all your company's direct and indirect costs for a clear picture of retained revenue. Companies with high net profit tend to be efficiently run and financially sustainable. They can also attract investors with the promise of substantial returns.
What Is a Good Gross Profit Margin?
The definition of a good profit margin varies by industry. A company that sells services rather than products or a consulting firm run by a sole proprietor has little or no COGS, which means these businesses earn almost pure gross profit. For example, NYU data indicates that the average gross profit margin for software and apps is nearly 72% and about 54% for other types of information services.
On the other hand, businesses with high COGS, like auto and furniture dealers, can have a much lower profit margin and still be financially healthy. Auto parts businesses average about a 15.6% gross profit margin while it hovers at about 30% for home furnishings.
This also applies to high-overhead businesses with need for significant space and labor, like food wholesaling, which has an average gross profit margin of about 15%.
What's a Good Profit Margin for a New Business?
In general, 20% is a good profit margin goal for a new business. Most companies can expect to earn a profit margin of around 10% based on industry and economic factors. If your business has a lower profit margin, it's time to make changes to accelerate sales performance and decrease overhead.
How Can You Increase Your Profit Margin?
These strategies can produce a positive change in your small business profit margin.
Negotiate Variable Expenses
You may be able to save on operating expenses by asking for lower costs and more favorable terms for your bills. Examples include better rent for your commercial space, whether you have an office, warehouse, storefront or multiple properties.
Your business can also try to find lower rates for materials and supplies. A good relationship with vendors and bigger orders over time both support your case for a discount.
Spend Less on Labor
You might be able to reduce the amount you spend on internal employees as well as contractors and freelancers. Consider these payroll-decreasing ideas:
- Reviewing process efficiency if you're spending significant funds on overtime
- Training employees in multiple areas to optimize their capabilities and reduce retention
- Evaluating the money spent on external services and determine whether you really get a return from outsourcing these items.
Consider Raising Prices
Conducting a thorough competitive analysis can help you understand whether you can boost prices for your products and services and still retain your customer base. When you have a target profit margin in mind, you can run the numbers to see how much you'd actually have to increase costs to make that goal a reality. You can also decide whether the market will support the higher rate or take their business elsewhere.
You may be able to reduce the impact of higher prices by adding features that boost the perceived value. If your audience feels like they're getting a great deal on something unique, they'll be more likely to stick with your brand through the price increase.
Optimize Your Checkout Process
Cart abandonment can take a serious cut of your revenue. Often, customers ditch their potential purchase before checkout because they aren't sure they can trust the business with their payment details.
When you use Pay.com, you can quickly and easily create an ecommerce experience that aligns with customer expectations for your brand. Logo, appearance, and message that match the rest of your online presence increase conversions by building browser familiarity with your business. You can also add security badges to show you'll protect personal information with the highest level of compliance with industry guidelines.
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Cater to Existing Clients
You'll spend less money selling new products and services to your current clients than you will converting non-buyers to new customers. While you don't want to ignore conversion completely, it might make sense to invest more marketing resources on areas where you can upsell.
Start with these strategies to spark inspiration:
- Enhancing client experience with added features or special customer service channels
- Connecting with customers who've abandoned their carts, especially if they've bought from your business before
- Adding impulse buys to each product page, encouraging visitors to spend more money by mixing and matching complementary items.
The Bottom Line
If you're not sure where to start with profit margin, research the norms for your industry to see where your small business stands. Most sustainable companies should spend no more than 85 to 93% of their revenue on operating expenses. Fortunately, you can improve this important financial metric by decreasing costs, increasing sales, or ideally both.
Pay.com provides an important piece of the puzzle when it comes to boosting profit margin. Our full-service solutions support the high-security transactions your customers expect, with an easy-to-customize checkout page that fits right in with the rest of your ecommerce site.