As a small business owner, your profit margin might feel like the clearest way to define your success. Considering how hard it can be to keep your head above water, especially in the early days of your venture, breaking even (or even making a profit!) can give you the motivation you need to continue pushing forward.
While you likely never expected to become a millionaire overnight, the initial investment of money into your business while you’re getting it off the ground, and the subsequent wait for profitability, can be challenging.
Coupled with the pressure of needing to prove to yourself and others that your business is working, having a good profit margin can indicate the health of your business and give you much-needed peace of mind.
From both an emotional and practical perspective, it’s important to know if the amount of money you’re netting at a particular stage in your venture is worth the blood, sweat, tears, and late nights that come with having your own business.
But balancing operating expenses with money earned, as well as factoring in future expenditures, can make it tricky to determine at what point is your business making you money. If you’re wondering how to determine if you’re profiting a normal sum for your industry and if your ROI is standard for your space, you’re not alone.
Let’s break down the key terms around profit margin, whether or not your expectations are realistic, the difference between profit margin and ROI, and how to increase your profit margin.
What is a profit margin?
The term profit margin refers to the amount of money your business makes, after you deduct all of your business’ expenses. This could mean your profit after paying your rent, taxes, salaries, supplies, and other regular expenditures.
It’s important to note that there are several different types of profit margin which banks and other financial institutions, as well as investors and accounts, use in order to gauge the financial health and success of your business.
Operating profit margin
Operating profit margin is a specific definition of profit margin. It refers to the money made by your business after subtracting your operating expenses and cost of goods sold.
Operating expenses (OPEX) typically covers expenditures like wages for your employees and the rent for your location, while cost of goods sold (COGS) refers to the direct cost to your business for the products or services it offers customers. For example, if you own a bakery, the price of the wheat or dough you buy from a wholesaler falls into the COGS category.
Gross profit margin
Gross profit is determined by the amount of money your business makes, after deducting COGS only and not factoring in OPEX. In all likelihood, your gross profit margin will be higher than your operating profit margin, because it doesn’t include expenditures like rent and utilities.
Net profit margin
Your net profit is the money made by your business after subtracting OPEX, COGs, and other expenditures such as municipal, state, and federal taxes and interest on any loans you may have taken to finance your business.
Essentially, your net profit is how much money your business is actually making at the end of the day, minus all the money that you need to spend to actually operate your business, logistically and legally.
Net profit margin is a metric which is found after taking your net profit, dividing it by your revenue, and multiplying that figure by 100.
What is a good net profit margin ratio?
A good net profit margin ratio varies by industry, years of continuous operation, global location, and a number of other factors. But there are general ranges and rough estimates for what’s considered a good net profit margin.
According to the Corporate Finance Institute, a 20% profit margin is considered excellent, a 10% profit margin is average, and a 5% profit margin indicates that a business is struggling.
If your new business is hovering below the 10% mark, don’t worry! Bear in mind that these averages are slightly different for small businesses. Industry titans like Amazon and Apple hover around the 20% net profit margin.
For a small business, a net profit margin of 7% to 10% is considered solid, according to Investopedia.
Average gross profit margin by industry
Gross profit margin is found by taking a business’ gross profit (the amount of money left after deducting COGS) and dividing that by the number of sales. Notably, what’s considered a gross profit margin is wildly different depending on the industry.
According to CFO Hub, restaurants and dining businesses typically average 27.60% gross profit margin. However, the average net profit margin for restaurants is a much more modest 5.69%.
eCommerce sites average 42.53% gross profit margin, with 4.95% net profit margin. Notably, brick-and-mortar retail stores have a significantly lower gross profit margin of 24.27%, and lower net profit margin of 2.79%.
Transportation businesses have an average 19.91% gross profit margin and 3.88% net profit margin.
Computer services companies typically have a 27.16% gross profit margin and 3.62% net profit margin.
Software companies have an average gross profit margin of 58.58%. But these same businesses average a -5.60% net profit margin, suggesting that many are investing so many funds and resources into developing their products that they aren’t profitable.
Profit margin vs ROI
As we defined earlier, your profit margin refers to the money netted by your business after your expenses are subtracted. ROI (return on investment) is a related, but not identical, concept.
ROI is a metric that gauges the money that you make by selling a product, based on the investment that you made in obtaining or creating the product.
Let’s say you’re spending a ton of money via manpower or sourcing materials for a product. If the difference between the final price at which the product is sold and the cost of making it is small, your ROI is going to be low.
Both ROI and profit margins are helpful tools for judging your business’ financial status, but they don’t indicate exactly the same thing. In the same way that your net profit isn’t necessarily a reflection of the overall financial success of your business, you can’t look at ROI as a stand alone, end-all, be-all indication of whether or not your business is succeeding.
You should calculate ROI and your profit margins as part of a big picture approach to your small business financial strategy, along with other tools and metrics, to get an overall view into what’s working and what’s not within your venture.
How to improve your profit margin
If you ask 3 financial or business experts for the best ways to improve profit margin for your business, you will likely get 3 very different – and maybe even – contradictory answers!
The truth is that there’s no magic formula for improving your profit margin, and there’s no one-size-fits-all solution. Each business has its own unique needs, challenges, and strengths, varying by industry, geographic location, and a plethora of other factors.
With that being said, there are a few simple tips you can consider for improving your small business’ profit margin.
Boost your average order or purchase value
While it’s easier said than done, getting both loyal and new customers to spend more when they purchase from your business can help increase your profit margin.
You can do this by incentivizing larger purchases with free shipping (if you’re an online business), complementary gifts should a customer spend over a certain amount of money, establishing loyalty programs that reward regular and consistent customers, and even good old fashioned upselling.
In today’s hyper-competitive landscape, ensuring that your business has a stellar reputation when it comes to customer service and client experience is key. Fostering a strong sense of brand loyalty and trust in the quality of your products can also increase the average purchase amount at your business.
Streamline your OPEX
A quick way to improve your profit margin is by lowering your operating expenses. This could mean implementing new policies which reduce waste.
Do a thorough review of your business’ operating expenses and figure out where your weak points lie, then determine how you can cut back in areas that are costing you too much money for too little return.
For example, if you’re buying too much of a specific material or product and end up throwing a third of it away at the end of the day, reducing your order to your wholesaler can easily lower your operating expenses and therefore boost your profit margin.
A good profit margin is important, but not the only thing that matters
While calculating your profit margin is an important step for gauging the financial health of your business, you should remember that profit margin, ROI, and other metrics are only part of your business’ story.
In today’s rapidly evolving market landscape, volatility stemming from global events to local regulations can mean that a business’ finances can fluctuate from year to year.
Stability and consistency is hard to find, and if your business is turning a steady profit, don’t fret if your net profit margin is less than 5%.
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