Looking at your profit margin is among the quickest and simplest ways to gauge the health of your small business. Profit margin details how much of your revenue stays as profit instead of being lost to business costs and expenses. Your profit margin can also show you how much money your business makes each time you sell a product or service.
What is the profit margin?
Profit margin is the ratio of a business’s profit to its revenue. Profit margin can be expressed via the profit margin formula:
Profit margin = Profit/Revenue
Although the profit margin formula is often displayed as a fraction, your small business’s profit margin value will always be displayed as a percentage. Since profit is by definition less than revenue, your profit margin will always have a value of between zero and 100 percent.
What are the three types of profit margins?
The profit margin formula can be extrapolated to encompass three types of profit margins:
- Gross profit margins. This category of profit margins compares your small business’s revenue to its variable costs. The formula for gross profit margins is the same as for your profit margin, but gross profit (revenue less the sum of materials, labor, and overhead) is substituted for total profit. The formula should look like this:
Profit margin = Gross profit/Revenue
The gross profit margin may also be known as the cost margin or direct cost margin. - Operating profit margins. For the operating profit margins formula, simply replace the profit figure in the profit margin formula with your operating profit. It should look like this:
Profit margin = Operating profit/Revenue
To calculate operating profit, find the sum of revenue and cost of goods sold (COGS), then subtract your small business’s selling and administrative expenses. - Net profit margins. For the net profit margins formula, replace the profit figure in the profit margin formula with net profit. It should look like this:
Profit margin = Net profit/Revenue
To calculate net profit, subtract COGS, depreciation and amortization, tax, interest, and all other expenses from your total revenue.
Why is profit margin important?
It is important to maintain good profit margins so that you can receive financing. Good profit margins reflect that a large amount of your revenue is ultimately making it to your small business’s bottom line. In layman’s terms, good profit margins reflect good, trustworthy business practices and steady profits and thus open the door to financing opportunities for your business.
Additionally, when you understand your small business’s profit margins, you can better see whether your business is faring well. A poor profit margin can help you to flag and resolve issues with your business spending, and as you identify problem areas, your profit is likely to increase. Similarly, comparing your profit margin to the standard in your industry and region can illuminate any potential needs for growth.
How is profit margin calculated?
According to the profit margin definition, profit margin is calculated simply by taking profit – or, when applicable, gross profit, operating profit, or net profit – and dividing it by revenue. You should also note that to calculate your profit margin is a different operation than to calculate your profit percentage. Whereas profit margins are based on revenue, to calculate your profit percentage, you divide profit by cost instead.
Seven ways to improve your profit margin
Since good profit margins reflect a healthy small business, you may be wondering how you can change your business practices to improve your profit margins. The below seven methods can help increase your profit margins:
1. Decrease expenses
Profit margin is the ratio of profit to revenue, and profit is the difference between revenue and costs. By definition, profit increases when expenses decrease. As your profit increases, so too will your profit margin, so start by decreasing your expenses.
2. Cut underperforming products and services
If certain products and services that you offer aren’t turning a profit or aren’t bringing in enough money to justify continuing them, cut them. With fewer unprofitable or low-profit services under your company’s roof, your profit margin is more likely to increase.
3. Expand product offerings and services
Alternatively, if you can identify an unaddressed need among your target audience or market (or existing customers), expand your product offerings and services to include solutions to these problems. Theoretically, when you offer customers a solution to an identifiable need, they will take it, and with every sale you make, your revenue should increase.
4. Increase pricing
Among the quicker, simpler solutions for addressing a poor profit margin is to increase your pricing. If you earn more money on every sale you make, your profit should increase. That said, be careful not to increase your price so steeply that you lose existing customers or have difficulty acquiring new ones. If you remain unsure how large of a price increase is too large, check your competitors’ prices.
5. Promote your company
Marketing initiatives can help introduce new customers to your products and services or remind longtime customers of your brand’s value. If the costs often associated with marketing deter you from pursuing this path toward increasing your profit margins, keep in mind that almost all methods for increasing your profit margin will require you to spend more money (or at least change the way your money is spent).
6. Optimize vendor relationships
If you need to increase your profit margins and your small business works mostly with vendors with whom you have long, trusting relationships, you can optimize your vendor relationships to cut costs. Whether you renegotiate your contract with your vendors to cut your costs or use your vendors to begin offering new services (or streamline existing ones) that boost your profits, starting a conversation with your vendors may well be worth your time.
7. Increase average order value
In retail, average order value (AOV) describes the ratio of your small business’s total revenue from sales to the number of orders your business receives. Consider implementing changes that increase your AOV, whether deals that encourage customers to buy more items during their orders or price increases that, in turn, increase your total revenue from sales.
Your profit margin and the health of your business
No matter how you calculate it, a good profit margin signals a healthy business to partners, investors, and lenders, among other entities that can help your business grow. Improving your profit margin is only one way to grow and expand your small business, though.
