It doesn’t matter how much revenue you’re raking in or how many products you sell. If you do not have a good profit margin, your cash flow will suffer. A good profit margin is a mandatory requirement for a successful business. It shows that in addition to sales, the other financial elements of your business are under control as well.
The best practices for maintaining a good profit margin, however, often go ignored. Luckily, these guidelines are essentially the same tactics for maintaining strong cash flow in general.
In this guide, we’ll explain what makes a truly “good” profit margin, why profit margin is so important, and what you can do to establish a good profit margin for your industry.
What is a profit margin?
The basic definition of profit margin is the percentage of revenue earned after all expenses have been deducted. In other words, this is the amount of money your business earns compared to the amount of money your business spends.
Only after taking every single expense and revenue source into account can you obtain an accurate profit margin. This includes taxes, transaction fees, depreciations, etc.
What is the formula for calculating profit margin?
The formula for calculating profit margin is very simple:
Profit Margin = (Total Sales – Total Expenses)/Total Sales
There are two kinds of profit margins: net profit margin and gross profit margin. The above formula will produce your net profit margin, or the profit margin of your entire company.
In order to calculate net profit margin, take the company’s revenue over a given time period and subtract that number from the amount of money the company spends over that same period. Then, divide that number by total revenue.
For example, if your company earned $20 million in sales in a year and spent $15 million in the same time period, your net profit margin would be 25%.
What is gross profit margin?
Gross profit margin refers to the profitability of a single product or service. In order to calculate gross profit margin, take the retail price of a product or service and subtract the cost of producing it. This includes the cost of materials along with labor. Then, divide that number by the retail price.
For example, if you sell a product for $10 that costs $5 to make, the gross profit margin is 50%.
Why are profit margins important to know?
Failing to monitor profit margins often leads to major cash flow problems going ignored. Countless business owners believed they were doing well because, on the surface, they didn’t notice any serious issues. Had they kept tabs on profitability, they would have received a reality check before the issue escalated beyond their control.
Hence, the importance of profitability can be derived from the importance of solving financial problems before they escalate.
Benefits of keeping tabs on profitability
Business Growth: The obstacles that are inhibiting profitability will logistically inhibit growth as well. You can’t grow your business if you are spending too much money on a certain area, pricing your products too low, etc. And when you are in the process of executing a growth strategy, the status of your margins will tell you if your strategy is truly effective.
Business Loans: A good profit margin is a crucial requirement for many financial institutions offering small business loans. This tells them that the business owner is responsible enough to make sure expenses, inventory prices, and other elements that affect profitability are under control. Institutions will also likely be pleased to hear that one of the primary goals of your desired investment is to increase profitability.
What is a good profit margin?
Every industry has its own standards for what constitutes a “good” margin. If your industry has low overhead costs, the standards for a good margin are higher. The opposite is true for industries with high overhead costs, like restaurants or retail.
For example, while the expected net profit margin for a restaurant is around 3%, an advertising firm is expected to have a net profit margin closer to 6%. The alcohol industry has one of the highest average net profit margins in existence at just over 19%. It’s no wonder this industry is widely considered to be “recession proof.”
As you can see, the difference between two industries’ standards for a good profit margin can be quite drastic. Here are three other major factors to keep in mind when determining what your company’s margins should look like at this stage of the journey:
3 additional factors that affect profitability
Geographical Location: Different states and cities have different costs for numerous business expenses like rent, labor and utilities. If your location has lower costs than the majority of the country, you might want to shoot for a profit margin that is slightly higher than the industry average.
Expansion Goals: Let’s say your company has reached a point where you have all the resources you need to serve your customers and sustain operations. There is plenty of money left over after covering business expenses. You don’t have to expand your team, buy more equipment, or increase the size of inventory orders to meet your current obligations.
Of course, acquiring more resources would likely allow you to serve more customers and make more money, but you are perfectly satisfied with what you have right now. If you wanted to grow your business, you would likely have to raise your profit margin. But since growth is not on your to-do list, your current margin is just fine, even if it is just “average” according to industry standards.
Time in Business: New businesses have lower overhead costs, which creates higher margins. That figure is logistically expected to drop, however, as the business grows. The business might be earning more revenue but is unable to bring its net margin back to the previous range.
You’d think that steady increases in revenue would automatically increase profitability. This is not the case, and that’s perfectly normal for a growing business. So, don’t be alarmed if profitability decrease as income increases. As long as you keep tabs on margins, you’ll notice when it’s time to take another look at overhead costs.
How can you improve profitability?
Cut Expenses: There is always more you can do to save money. First, consider eliminating or decreasing non-essential expenses like travel, office space, memberships or software tools. You may also be eligible for better rates from credit card vendors or suppliers. If you always pay on time and have amassed a long track record of orders, you have earned the right to ask for a discount.
Decrease Delinquent Payments: Most businesses that collect payments via invoices give customers 30 days to pay. This seems reasonable since business expenses are due in a month’s time. But late-paying customers are basically unavoidable. The longer it takes for payment to come in, the less profitable the sale becomes.
Thankfully, there a number of solutions for this common problem. You could send more than one invoice per month, offer discounts for clients who pay early, or only offer 30-day terms to clients with flawless payment histories.
Inventory Management: Items lose profitability and eat up working capital when they sit on your shelves for months on end. The goal is to keep just enough stock on hand to meet demand. Orders should therefore be placed shortly before the items will be sold. Many businesses implement this strategy with a business line of credit, which allows them to place orders at sporadic intervals.
Which strategy should you use?
It’s clear that there are quite a few ways to improve profitability. Rather than trying your hand at each option, it’s much less time consuming to talk to your accountant and find out which actions need to be taken. Figuring out the next moves to make in general is much easier when you keep a close eye on profitability. In most cases, the correct growth strategy is the one that has the highest likelihood of improving profit margins. Sometimes, it just takes a while to figure that out.