Starting your own business is exciting! You don’t have a boss to answer to anymore and you get to do what you love. Being an entrepreneur isn’t all fun and games though. Success as a small business owner depends on paying attention to how much money is coming in and how much is going out.
First and foremost, these metrics tell you if it’s worth it to keep running your business. They can also tell you what areas to cut costs for and when you need to raise prices. Financial statements are also important for building partnerships with lenders, investors, and vendors. The metric these parties will most want to see is your profit margin.
But what is a profit margin? How do you know if yours is good? How can you improve the profit margins for your business? Hold onto your seat because we’re about to break it down in this complete guide!
What is Profit Margin?
The profit margin represents the total percentage of sales that result in a profit. A company's profit margin tells investors, creditors, and other interested parties how well the company handles their money.
This is the formula for calculating your profit margin:
Profit margin = Net income / Revenue x 100
Why is a Healthy Profit Margin Important?
Your profit margin shows how much of every revenue dollar is flowing to your bottom line. It can help you quickly locate pricing problems, which can prevent future cash flow challenges.
Types of Profit Margin
There are several types of profit margins. The most common are
- Gross profit margin,
- Operating profit margin
- Net profit margin
Gross Profit Margin
The gross profit margin, also known as gross margin, represents the amount of profit made before deducting selling, general, and administrative costs, but after deducting the cost of goods sold (COGS). Companies use it to find how the production costs relate to their revenues. Service-based industries usually have higher gross margins than product-based industries because they have lower COGS. The gross profit margin is the easiest profit margin to calculate.
Gross Profit = Revenue - Cost of Goods Sold
Operating Profit Margin = (Gross Profit/revenue) x 100
Operating Profit Margin
The operating profit margin, also known as the operating margin or return on sales (ROS), demonstrates how much profit a business makes on a dollar of sales after paying for variable production costs like wages and raw materials, but before paying interest or taxes. The operating margin is a good indicator of how efficiently a business is at making profits from sales. This margin is calculated by dividing the operating income by the net sales.
Operating Profit = Revenue - Cost of Goods Sold - Operating Expenses
Operating Profit Margin = (Gross Profit/revenue) x 100
Net Profit Margin
The net profit margin or net margin measures is the ratio of net profits to revenues, usually expressed as a percentage. The net margin demonstrates how much of each dollar in revenue a business collects translates into profit.
Net Profit = Revenue - Cost of Goods Sold - Interest - Taxes
Net Profit Margin = (Net Profit/ Revenue) x 100
Differences Between Your Gross, Operating, and Net Margins
The best way to understand the differences between the different kinds of profit margins is to look at a real-world example. In 2020, these were Amazon’s profit margins:
Gross profit margin: 26.06%
Operating profit margin: 5.29%
Net profit margin: 3.36%
Each margin accounts for more of the company’s spending, so the more you subtract, the smaller your margin will be. Your business may have a less drastic difference between gross profit margins and the other two margins since a huge company like Amazon has much higher operating expenses than the average small business. Bigger companies often operate under thin net margins.
Average Profit Margins by Industry
What’s the magic number for a good profit margin? That depends on your industry and the size of your company. In general, the sweet spot will be between 5% and 10%. Here are the average net profit margins for small businesses in a variety of different industries:
Auto and truck: 3.04%
Beverage (alcoholic): 7.94%
Beverage (soft): 18.50%
Brokerage and investment banking: 17.62%
Building materials: 4.30%
Business and consumer services: 3.83%
Computer services: 4.34%
Engineering and construction: 1.00%
Farming and agriculture: 2.47%
Financial services: 26.94%
Household products: 4.73%
Information services: 19.13%
Investments and asset management: 21.06%
Real estate: 19.75%
Restaurants and dining: 10.57%
You can see the full list as well as the gross margins, operating margins, and more financial metrics for each industry here.
Industries With the Highest and Lowest Profit Margins
The industries with the highest gross margins have:
- Low operating costs
- Little to no inventory
- High-cost products
- Service-based offerings
- Low numbers of employees
Some examples of high-margin industries include:
- System and application software companies
- Information service companies
- Telecom equipment
- Precious metals
On the other hand, industries with the lowest gross margins have
- High operating costs
- Large and complex inventory needs
- High numbers of employees
- Low-cost and perishable products
Some examples of low-margin industries include:
- Grocery stores
- Food wholesalers
- General retail
The age, size, and location of a business also affects its profit margin. Newer businesses often have higher profit margins since they don’t have many employees or need large rental spaces yet. This means they have low overhead expenses. Businesses in areas with high real estate costs usually have lower profit margins than those in areas with low real estate costs.
Ways to Improve Your Profit Margin
The most effective ways to improve the profit margins of your business are:
- Increasing prices
- Decreasing expenses
- Increasing sales
- Offering high-margin products
- Encouraging customer retention
Improving these areas of your business can lead to higher profits and open the door for growth in other areas of the business.
Your pricing strategy is a major player in achieving good margins for your business. Plenty of business owners are understandably hesitant to raise their prices. After all, if your prices get too high, your customers might go to your competitors instead. However, that doesn’t mean raising prices is always a bad idea. If your business is growing and demand for your products or services continues to rise, you might need higher prices to maintain your market share.
Decrease Business Expenses
Lowering your expenses is another way to improve your profit margins. Some suggested cost-cutting measures include:
- Using less expensive suppliers
- Cutting back on non-essential expenses
- Negotiating lower rates on services like
- Equipment repair
- Business software
- Downgrading existing services
- Choosing what to sell to avoid high shipping costs
If any of those options are available to your business, they can go a long way in lowering your expenses without hurting the quality of your products. This could lead to higher profit margins.
Obviously, every business wants more sales. More sales also mean higher profit margins. If you manage to increase your sales enough, you can achieve a higher profit margin without cutting costs or raising prices.
Offer High-Margin Products
Each product you sell has a different profit margin of its own. That means you can improve your overall profit margins by focusing on selling high-margin products and eliminating low-margin products from your offerings. Do a little research on products in your industry with the highest and lowest profit margins so you can choose the best fits for your business. It can be tempting to raise your margins even further with big markups on your products, but that can easily backfire by scaring customers away.
Encourage Customer Retention
Loyal customers don’t just mean you can expect more sales. They also save your business money. Attracting new customers can cost businesses 5 to 25 times more than retaining existing customers. With a customer loyalty program, it’s easy to reward customers for coming back for more. These programs can also lower your advertising expenses and increase your total sales.
How Sav Can Help
To get a good margin, you have to get your business off the ground and on the internet in the first place. Here at Sav, we’re dedicated to helping small business owners succeed online and elevate their passions. That starts with your own beautiful, professional website and a custom domain. No matter what industry you work in, how many employees you have, or who your target audience is, building and managing your website is easy and affordable with Sav. Start your free trial today to learn how!