Profit margin is perhaps one of the most important indicators of business success.
After all, tp survive as a business owner, you need to make more money than you spend.
But as you already know, that's easier said than done.
Generally speaking, it takes small businesses at least two to three years to start turning
a profit.
However, this number can vary widely, depending on how much capital is needed to start your
business, how much money it takes to provide products and services, how high your operating
costs are, and the amount of money you need to draw from the business to pay yourself
for your hard work.
All these expenses need to be subtracted from your business's revenue to figure out your
profit margin.
But that definition is too simplistic.
Keep watching and we'll show you exactly how to find profit margin, its importance for
your businesses long term outlook, and some tips on how you can improve your profit margin.
To define profit margin, use the following formula.
Profit Margin equals net income divided by net sales where net income is total revenue
minus business expenses and net sales is gross sales minus discounts, returns, and allowances.
This formula is also known as net profit margin, and it's used to determine an entire organization's
profit margin.
As an example, let's say you were trying to determine your business's profit margin for
a given year.
In that year, your company generated $200,000 in net income and $600,000 in net sales.
Divide 200,000 by $600,000 and you're left with 0.33 or three or 33%.
This means your business was able to generate $600,000 in sales while only spending $400,000,
leaving you with $200,000 in profit.
Said another way, 33% of every dollar you earned went to profit.
Now, there's another type of profit margin formula you should be aware of called gross
profit margin.
This is another important metric you can use to determine your business's financial health.
Let's take a closer look at it.
Gross profit margin is used to determine the profit margin of a single product or service.
To find gross profit margin take the retail price of the product or service and subtract
the cost of materials and labor.
Then divide that number by the retail price.
So say if you sell a product that costs $25, and it takes $20 to make.
Your gross profit margin is 20%, which is good.
This means you turn a profit on that product and the more you sell of it, the better it
is for your bottom line.
Now in order to be able to perform these calculations accurately, you need to keep track of all
your expenses and revenue generators.
This includes things like payroll, utilities, transaction fees, and shipping costs.
Fortunately, every number you need to calculate profit margin should be available on your
profit and loss statement.
Overall, by understanding your profit margin, you'll be able to see how many revenue dollars
are going toward your bottom line, as opposed to simply covering expenses.
Next, let's talk about why profit margin is important.
As you might have already guessed, having a positive profit margin means you're making
money.
But beyond making money, why is tracking your profit margin important?
Well, first of all, it helps you figure out how much you can reinvest to grow your business.
With gross profit margin you can determine which of your products are underperforming
and hurting your bottom line.
With the knowledge of what's costing you money and what's making you money, you can make
more educated decisions on what you need to do to grow and expand your business.
Secondly, knowing your profit margin helps you identify issues and resolve them quickly.
If your profit margin is low, you'll know you need to dive into the numbers and determine
what the root cause of the low profit margin is.
Maybe your pricing your products too low or doing a poor job of managing expenses.
Lastly, if you're seeking any type of business financing, lenders are going to want to know
where your profit margin stands before giving you a small business loan.
If your business has a high profit margin, you’re less risky to lend to and can likely
secure better rates.
On the other hand, if your profit margin is low, you'll have a hard time securing financing.
So what's a good profit margin?
Obviously, a positive profit margin is better than a negative profit margin.
But there's no hard and fast number that is indicative of a good profit margin.
The closest we can get to what a good profit margin is is the S&P 500’s blended profit
margin, which tracks the net profit margin of a sample of businesses across all industries
that is indicative of the larger market.
For Q2 of 2019, the blended net profit margin was 11.3%.
But while this was the median number, the net profit margin by industry varied greatly.
For example, according to an NYU study, the net profit margin in the advertising industry
was 3.1%, while the net profit margin in the alcoholic beverage industry was 24.3%.
This shows an important insight.
The industry you operate in affects what your profit margin is.
A business with low overhead costs like alcohol will have a higher profit margin than a business
with high overhead costs like advertising.
However, this doesn't mean the business with the higher profit margin has more profit.
Even though the advertising business has a lower profit margin, it generates more revenue
than the alcoholic beverage industry according to statista, which means it makes more money
and profit, albeit on a lower margin.
Here's an example of the profit margins in other industries.
Your profit margin is also impacted by your geographic location.
A restaurant in say, New York City, has higher overhead costs but also likely generates more
revenue than a restaurant in say, Waco, Texas, which probably has lower overhead costs.
Because of this, the New York restaurant’s profit margin will likely be lower.
If your business is expanding, your profit margin will also likely be lower because you
are reinvesting more of your profit back into the business, which counts as a business expense.
As your business grows, your profit margin may also decrease thanks to higher overhead
expense costs, like payroll.
A great example of this is Walmart.
Walmart has a net profit margin of around 2.5%.
But they still turn a huge profit thanks to high revenues.
Now that you know all about the importance of profit margins, you're probably wondering
how you can improve yours.
There are a couple of tried and true methods to improving profit margin.
The first is to decrease expenses while still making sure you can produce a quality product.
To do this, cut underperforming products or services that are hurting your bottom line.
You can identify which products are underperforming using the gross profit margin formula that
we spoke about earlier.
Increase product offerings or services by looking for opportunities to do more with
what you already have is another approach.
To do this, you can increase pricing.
This can sometimes be a tough decision, especially if you're competing with larger companies.
But sometimes it's necessary for your business’s long term survival.
And that's everything you need to know about profit margin.
As you go forward with tracking profit margin for your business, be sure you document every
expenditure and revenue source, as this is the only way to gain an accurate picture of
your profit margin.
For more tips and advice on running your business visit fundera.com.
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videos.
Thanks for watching, everyone.