Profit Margins: Charging More and Reducing Costs

Small businesses like yours succeed or fail depending on how profitable you are. Get profitability right, and you can grow revenue and thrive. Get it wrong, and you’ll run out of money and be forced to close. We want you to succeed, so here’s a primer on building profitability and creating a healthy, sustainable business. Before we dive into how you can increase profits, let’s explore what we mean when we talk about profit margins.

Profit Margins Explained

A profit margin is simply the difference in what you pay to produce goods and how much revenue you bring in from selling them to a customer.

Your business, The Blue Widget Co., produces blue widgets at a raw materials cost of $2 each. You then sell each blue widget to your customers for $5 each. You believe your profit margin is $3.

This is a simple explanation, but in the real world profit margins are never that straightforward. Here’s why:

  • The price you charge differs between customers
  • The cost of raw materials, goods or services changes over time
  • There are operational and hidden costs across your business that need to be covered by sales as well

Profit margins are slimmer than you think. They are also dynamic, changing as prices and costs vary. If you want to run a profitable business, you need to get on top of your profit margins.

How to Understand and Increase Your Profits

There are three important steps to understanding and increasing your profit margins:

  1. Understand how big your current profit margins are.
  2. Increase what you charge for your goods and services.
  3. Reduce what you pay out in costs.

We’ll explore all of these, but at the heart of profitability is understanding the concept of profit margins.

Step 1: Understand How Big Your Current Profit Margins Are

The most vital part of your profit margin is understanding all the costs that go into producing a product or service. These come in three flavors:

  1. Costs that can be calculated on a “per product” basis including raw materials, manufacturing, service provision, etc.
  2. Operational costs incurred in your business like rent, maintenance, advertising, utilities, distribution, salaries, etc.
  3. Hidden costs like taxes, merchandise returns and customer service

You calculate your costs by working out how much you pay for each of these areas, then adding them together and applying that to each product you sell.

Let’s get into the math.

Per product costs: Add up the total cost of raw materials, manufacturing, salaries of people delivering services, etc. Calculate all these total costs to produce one “unit” of what you sell.
Operational costs: Explore all the other expenses your business incurs like logistics, shipping, distribution, utility bills, rental, sales, marketing, websites, payment processing, etc. Look through your finances and bank statements to find everything your business spends money on. Add up your average operational costs on a monthly basis.
Hidden costs: These are the areas you don’t necessarily think about like exchange rate charges, taxes, customer service costs, etc. Add up your average hidden costs on a monthly basis.
Units sold: Work out how many units of products or services you sell every month.


Working Out Total Cost Per Item
It's time to calculate your profit margin.

  1. Add together operational and hidden costs
  2. Divide that by the total number of units you will sell in a month
  3. Add that figure to your cost per unit
  4. The result is your total cost per unit

The Blue Widget Co. works out costs as follows:

Cost per item

$2/unit

Operational costs

$10,000/month

Hidden costs

$5,000/month

Widgets sold per month

10,000

Cost (operational + hidden)

$15,000/month

Unit cost (cost divided by units sold)

$1.50/unit

Total cost (unit cost + raw material costs per unit)

$3.50/unit

Selling at $5 means the profit margin is now $1.50 per unit.

Once you have your total cost per item, you can look at increasing customer prices and reducing costs.

Step 2: Enhance Profits by Increasing the Prices you Charge Customers

The simplest way to increase profits is to charge your customers more, but there are several areas you need to take into account.

What Are Your Competitors Charging?

It’s a very competitive marketplace out there! Look at how much your competitors are charging for the same or similar products and price accordingly. Set up monitoring on your competitors’ pricing so you can react quickly to changes.

Can You Create Different Tiers of Pricing?

All your customers are different. Some will want “budget” versions of items with basic features and functions, while others will want enhanced capabilities. You can take advantage of this by creating tiered pricing, offering variants of your products or services at each price point.

Are You Sharing Your Benefits and Unique Selling Points?

If you're charging more, you may have to offer more. Explain this clearly to your customers. If you’re providing higher quality, faster service, a personalized approach or something else, make sure you bring that out in your marketing. That way, customers can see that even though your item is more expensive, they get more benefits.

Will You Test and Refine Your Pricing Strategy?

Finally, make sure you test and tweak your pricing strategy. Keep careful records of how price changes influence sales so you can tweak and refine over time. Find the optimal balance of pricing, profitability and the number of units sold.

Step 3: Enhance Profits by Reducing Costs

The third way to increase profits is to reduce what you pay for each unit. This is where your profit margin calculations will be useful, since you’ve already analyzed and understood all of your costs.

Can You Reduce the Cost of Materials or Manufacturing?
Look at how much you’re paying suppliers for materials or to make the products in the first place. Explore whether you can buy in larger amounts to reduce the cost per item. This can also help reduce your distribution costs. If you’re paying someone to provide services, look at ways to make that more efficient through automation or software.

Can You Reduce Operational Costs?
Operational costs are one of the main places you can make savings. Analyze your marketing and sales efforts to maximize your return on these investments. Use software to automate parts of your business. Think about charging slightly more to cover distribution costs. Go through your operational costs line by line and ask how you can reduce them, even by a small amount. It all adds up.

Can You Reduce Hidden Costs?
Hidden costs are another treasure trove of cost reduction opportunities. Talk to your accountant about reducing your tax burden. Create self-service facilities for your customers to reduce customer service costs. Try to reduce payment processing or exchange rate fees. Again, look at all your hidden costs and find money-saving options if you can.

That’s it — once you understand your profit margins, you can tweak your pricing and see how that impacts on sales. At the same time, work on reducing costs. When you can balance the cost per item with a good price point, you will create healthy profit margins, enhance profitability and grow revenue.

And that’s good for everyone.

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