Being profitable is every company’s goal. That’s the point of running a business, after all. However, as all entrepreneurs know, to achieve this is not as easy as it sounds. Since you usually have to spend money in order to make money, it can be difficult to keep track of your profit, revenue generation and other important financial information that is critical to the health of your business.
Companies use a plethora of metrics to measure their performance and financial health. Profitability is one of these, however, understanding what this truly is can be hugely complex. Calculating your profit margin can help with this but first it’s important to understand what this actually is:
What is profit margin?
Profit margin is one of the many metrics that pertain to profitability. It measures the degree to which a business makes money as opposed to its ongoing expenses. For example, if a business has a profit margin of 40%, that means for every dollar of sales, the company generates a profit of USD$0.40. Companies typically refer to net profit margin, but there are actually other types.
Different types of profit margin
If you want to use profit margin to get a clear picture of your company’s profitability and performance, there are generally three types as follows:
- Gross profit margin: This margin compares your revenue to the variable costs—costs that fluctuate as the number of goods your business produces changes. Examples of variable costs include raw materials, wages, commissions, packaging, and other expenses that you’d usually find in job estimates or invoices. Jobber is an excellent resource for doing just this and offer free estimate templates up to fully comprehensive business management software packages to support companies operating within the field service sector.
- Operating profit margin: This margin compares revenue to the variable costs in addition to fixed costs. For your reference, fixed costs refer to expenses that you must pay independent of business activities. In short, it’s the type of expenses that do not fluctuate. Examples of fixed costs include amortization and depreciation rates.
- Net profit margin: This is the highest level of profit margin. It compares your revenue to both the variable and fixed costs, along with interests and other deductions. You can say that the net profit margin is what’s left of your revenue after deducting all the expenses. It’s also the most commonly used type of profit margin by the vast majority of businesses. (1)
It’s important to realize that profit margin falls under three levels or types, especially since each type has different calculations and can tell you different things about your company’s profitability.
How do you calculate profit margin?
Although the three are essentially all profit margins, experts suggest that you calculate gross, operating, and net profit margins separately to get an accurate idea of your profitability. On that note, here’s a closer look at each of their calculations or formulas:
- Gross Profit Margin = Gross Profit / Revenue × 100
Gross Profit = Revenue – Cost of Goods Sold
- Operating Profit Margin = Operating Profit / Revenue × 100
Operating Profit = Revenue – Cost of Goods Sold – Operating Expenses (e.g., salaries, insurance, equipment lease payment, rent payments, phone service, etc.)
- Net Profit Margin = Net Income / Revenue × 100
Net Profit = Revenue – Cost of Goods Sold – Operating Expenses – All Other Expenses (e.g., taxes, interest payments, debt payments, etc.) (1)
Take note that all these come in percentages, although certain companies may refer to them in the form of ratios. Nevertheless, these are the formulas for all three types of profit margins.
The importance of profit margin to a business
Calculating your profit margin can involve a regular investment of time to ensure you get it absolutely right and are on top of your company financials. It is essential to understand this metric as it tells a lot about the financial health and sustainability of your business.
In that regard, here’s a closer look at the benefits of profit margins according to each type:
- Net profit margin: The net profit margin is what companies commonly use to get an accurate representation of their profitability, and for several reasons. First, it shows how much profit the company makes for every dollar in sales. Second, it provides insights on underlying issues concerning business expenses, especially if it’s exceedingly high. These are the reasons why most experts believe net profit margin is the most crucial type of profit margin. (2)
- Operating profit margin: While net profit margin certainly has several benefits, some experts believe that a company cannot avoid or minimize taxes or interest payments. For that reason, certain companies use operating profit margins in place of the net profit margin since, as operating profit margin does not include taxes or debts. By doing so, a company can discuss its financial situation more positively. However, it may be less accurate compared to when you use net profit margin, especially for organizations with expenses made up mostly of debts or loans. (3)
- Gross profit margin: While it may not be as accurate of a representation as to the other types, the gross profit margin can provide insights on how effectively you’re using your resources to produce goods. (4)
What’s a good profit margin?
This is the million-dollar question. How do you know if your profit margin is good or bad? A good profit margin varies depending on the industry. For example, the standard is pretty high for businesses offering high-end accessories and luxury goods like car manufacturers and gaming companies. This is often because their expenses are usually low since they’re less likely to mass-produce.
For instance, a gaming company may initially invest a lot of money into developing a game. But once the development is complete, they can make copies without spending much. On the other hand, labor-intensive businesses tend to have a lot of expenses. Common examples of such companies include transportation and agriculture-based ventures. Transport companies have to deal with fluctuating fuel prices, driver salaries, and vehicle maintenance. Meanwhile, agriculture ventures have to worry about storage space, inventory, and weather uncertainty.
These contribute to the standards of profit margin within the industry. But in general, a good profit margin should be around 20%–40%, depending on the industry your business is operating in.
Closing thoughts
Although the ultimate goal of any business is to become profitable, measuring profitability isn’t straightforward and involves complex calculations and an understanding of what the figures mean for you. To ensure that you can operate a steady, stable and sustainable business, make sure that you are fully up to speed with your profit margin and use this to help inform you in making strategic business decisions in order to grow and scale.
References
- “Profit Margin”, Source: https://www.credibly.com/incredibly/profit-margin
- “Why is net profit margin important?” Source: https://www.abrigo.com/blog/why-is-net-profit-margin-important/
- “Operating Margin ”, Source: https://corporatefinanceinstitute.com/resources/knowledge/accounting/operating-margin/
- “Why Is the Gross Profit Margin Important to a Company?” Source: https://smallbusiness.chron.com/gross-profit-margin-important-company-60365.html
