In our experience working with small business owners, the importance of having a good profit margin is often overlooked.
Below, you’ll learn what a profit margin is, why it is important for a small business, what types of profit margins there are, and what a good profit margin looks like.
Let’s get started!
What is a Profit Margin?
A profit margin is profit divided by sales. So, you subtract business costs from sales and then divide the result by sales to get your profit margin. The profit margin is expressed as a percentage, and measures the profitability of your business.
Why is Profit Margin Important?
Let’s look at a hypothetical example of how a low profit margin can significantly affect your net profits in dollars, compared to if you had a higher profit margin.
You have a business that generates $2,000,000 in net sales each year. Your net income is $200,000, giving you a net profit margin of 10%. The average net profit margin in your industry is 28%, however.
Let’s say you have to increase wages by $40,000 to keep up with market rates. All of a sudden, your net income sinks to $160,000 and your net profit margin drops to 8%. To “get back” that $40,000 in profit, you’d have to increase your sales by $500,000 or 25%!
With a 28% net profit margin and net sales of $714,286, you would have a net income of $200,000. With a smaller business, the wage increase would be a lot lower ($14,286 if it’s proportional). So, net income dips to $185,714 and net profit decreases to 26%.
But here’s the good news: you would only need a sales increase of $54,946 (7.69%) to make up for the lost profit.
Types of Profit Margins
Let’s look at four types of profit margins: gross profit margin, operating profit margin, pretax profit margin, and net profit margin.
What is a Gross Profit Margin?
Here’s how gross profit margin is calculated:
Gross Profit Margin = (Net Sales – Costs of Goods Sold (COGS)) / Net Sales
As you can see, selling, general, and administrative (SG&A) expenses are not factored in.
Gross profit margin is an important metric for companies with high COGS, such as manufacturers – isolating and tracking this metric over time provides valuable insights into the state of the business.
But for small businesses with low or no COGS, like consultants, gross profit margin doesn’t matter as much.
What is an Operating Profit Margin?
Here’s how operating profit margin is calculated:
Operating Profit Margin = (Earnings before Interest and Taxes (EBIT)) / Net Sales
EBIT is revenue minus (COGS + SG&A Expenses).
SG&A expenses include salaries, accounting expenses, marketing expenses, and rent, to name a few common items.
So, operating margin factors in operating costs, but not non-operating costs (interest and taxes).
Unlike gross profit margins, operating profit margins are a key metric in most industries – this margin accounts for a large percentage of the costs involved in running most small businesses.
What is a Pretax Profit Margin?
Here’s how pretax profit margin is calculated:
Pretax Profit Margin = (Earnings before tax (EBT)) / Net Sales
So, pretax profit margin is essentially operating profit margin minus interest.
A company with high borrowing costs might notice a big difference between operating margin and pretax margin. But in this case, the company should project future borrowing costs to determine the long-term trajectory of the business.
For example, a company with a 10% pretax margin and a 20% operating margin in an industry with an average pretax margin of 15% might be in solid shape – assuming the interest costs subside in the near future.
What is a Net Profit Margin?
Here’s how net profit margin is calculated:
Net Profit Margin = (Net Sales – COGS – All Other Expenses – Interest – Taxes) / Net Sales
Net income – aka “the bottom line” – is the most comprehensive measurement of profitability, and net profit margin is net income as a percentage of sales.
As a small business owner, net profit margin represents the percentage of each dollar of sales you can pay to yourself as salary.
While net profit margin is a key metric, its greatest strength (it includes everything) is also its greatest weakness. Let’s say you have a big one-off sale or expense – this could dramatically impact net profit margin, but would not accurately reflect the long-term profitability of the business.
What is a Good Profit Margin for Small Businesses?
A good profit margin is a profit margin that is higher than similar small businesses that operate in the same area you are active in. These are typically your direct competitors, or small businesses that are active in similar business verticals and product lines.
So, a good profit margin for a restaurant is different from a good profit margin for a software company.
Below, we will look at the profit margins of businesses of all sizes to show how much margins vary from industry to industry.
Across different industries, the average net profit margin is 8.89%.
Here are typical net profit margins in a five industries:
Real Estate (Development): 15.04%
Retail (General): 2.35%
Retail (Grocery and Food): 1.96%
Software (System & Application): 14.61%
Source: NYU Stern
Based on the above, a 5% net profit margin is outstanding for a Retail (Grocery and Food) company, but bad for a restaurant.
A big reason why profit margins vary from industry to industry is competition: a shopper can buy groceries from countless businesses, but a software company might have a unique solution.
The NYU data is useful to illustrate the significant differences in profit margin from industry to industry, but it’s important to focus on comparable businesses when evaluating your profit margins.
For example, if you have a restaurant in North Carolina with annual revenue of $3 million, you should not compare your profit margins to McDonald’s – look at similar restaurants in your city or state.
How to Improve Your Profit Margin
There are two main ways to improve your profit margin: increase sales and decrease costs.
Here are a few ways to do that:
- Focus on your most profitable products/services. Unless your company only sells one product/service, you likely have different profit margins across your offerings. A good way to increase your profit margins is promoting your most profitable offerings more and your least profitable offerings less.
- Increase sales faster than expenses: finding a way to not increase expenses proportionally to sales allows you to improve profit margins. Leveraging technology and giving employees the tools they need to increase productivity are two ways to do this.
- Cut unnecessary expenses. Do you have subscriptions that are collecting dust (figuratively)? Do you have more office space than you need? Consider all of the ways you can trim costs without having a negative impact on your small business.
- Retain existing customers: acquiring a new customer costs anywhere from five to 25 times more than retaining an existing one. So, keeping your existing customers around – perhaps with the help of a loyalty program – is one of the best things you can do for your profit margins.
- Cut credit card processing costs. Maybe it’s possible for you to reduce payment processing fees using surcharging or cash discounting?
The Bottom Line
A good profit margin is a huge part of short-term and long-term business success, and having a profit margin that is above your industry average gives you a competitive advantage.
In the short-term, a better profit margin means that your net income is higher, giving you more flexibility and better opportunities for business growth.
In the long-term, you are better able to weather unexpected storms (e.g., increase in expenses or decrease in sales). You are also better protected against forces that are out of your control – we all remember the COVID-19 pandemic.
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