One important metric to track in your business is the profit margin. This ratio tells you how much profit your company makes on each dollar of sales. To maximize your margin, you must understand what factors influence it and how you can improve it.
What is a Profit Margin?
The profit margin is the percentage of revenue that a company keeps as profit after accounting for all expenses. It is not the same as profit, the total amount of money (in dollars) that a company has left over after paying all costs.
How is Profit Margin Calculated?
To calculate your profit margin, you will need information found in the income statement. There are several margin ratios that you can calculate to get a better idea of how your business is doing.
Gross Profit Margin
The gross profit margin tells you what your company has made after paying for all the direct costs of creating a product or providing a service. To calculate the gross margin ratio, you must subtract the cost of goods sold from its revenue and then divide it by total revenue.
Gross Profit Margin = Revenue – Cost of Goods Sold ÷ Revenue
The cost of goods sold includes materials, labor, and overhead. This ratio can help you compare different companies or industries.
Operating Profit Margin
The operating profit margin measures what percentage of a company’s revenue is left after paying for its direct and indirect operational expenses. You can calculate it by dividing its total operating expenses by its revenue.
Operating Profit Margin = Total Operating Expenses ÷ Revenue
Operating expenses include things like rent, utilities, salaries, and depreciation.
The operating ratio is an essential metric for investors to consider when evaluating a company. A high operating ratio shows that a company is efficient at generating profits from its operations. Therefore, investors should look for companies with high margins as they are more likely to be profitable in the future.
Net Profit Margin
The net profit margin is a profitability metric that shows how much net income (after taxes and other expenses are considered) a company generates as a percentage of sales.
To calculate the net ratio, divide net income by total revenue:
Net Profit Margin = Net Income ÷ Revenue
For example, if a company has $100 in net income and $200 in total revenue, its ratio would be 50%. That means for every dollar the company brings in; it keeps 50 cents in profit.
How to Increase your Profit Margin?
There are many ways your business can increase its margin. One way is to increase your prices. Raising your prices may not be possible or practical in all cases. Still, if you can charge more for your product or service, you will automatically increase your margin.
Another way is to decrease your costs. You can negotiate better terms with suppliers, look for cheaper raw materials, or increase efficiency in your production process.
Finally, you can significantly increase your sales volume to impact your overall profitability. By selling more units at the same price, you will make more money and thus improve your bottom line.
Why is it Important to Know your Small Business’s Margin Ratios?
These ratios tell you what percentage of your revenue is left after accounting for your costs. In other words, it’s a measure of how efficient your business is at generating profit.
Here are some reasons:
- You can price your products or services more effectively
- It can help you identify areas where you need to cut costs
- You’ll get a better understanding of your business’s overall profitability
- It can help you decide which products or services to offer
Which Industries Have the Lowest and Highest Margins?
Here is a list of the sectors with the lowest and highest profit margins:
Industries with the Highest Margins:
- Tax Preparation Software Developers
- Optical Character Recognition Software
- Internet Radio Broadcasting
- Helium Production
- Urban Planning Software
- Conveyancing Services
- Iron Ore Mining
- Medical Equipment Rental
- Health & Welfare Funds
- Commercial Cooking Equipment Manufacturing
Industries with the Lowest Margins:
- Grocery Stores
- Auto Dealerships
- Restaurants and Bars
- Computer and Electronics Stores
- Beer, Wine, and Liquor Stores
- General Merchandise Stores