Let’s talk about profit margin…
When you’re running a business there are certain terms that come up over and over again. Especially when someone is asking you about the success of your business, profit comes up often.
A healthy margin is the life blood of a business because without it, there’s not enough cash flow to keep the business going.
That’s why in this article we’re covering how to calculate it and other types of margins that are helpful to know for any business.
Here’s What We’re Covering:
- What is Profit Margin
- Different Types of Profit Margin
- How Does Profit Margin Affect Business Decisions
- Wrapping This Up
What is Profit Margin?
Profit margin will tell a business owner how much profit to expect after the sale of a product or service. A higher margin will tell you that you’re going to have a more profitable business.
If you’re selling a product online for $20 and it costs you $10 to buy it and ship it to the customer then your margin is $10 or 100% because you’re selling the product for double what you paid for it.
It’s important to understand the different definitions for margin because when you start an online business it’s necessary to understand your numbers. Without a solid understanding you won’t know the health of your business.
Now, let’s talk about the different types…
Different Types of Profit Margin
Every small business from brick and mortar retailers, online retailers, to service businesses keep track of two types of profit margins:
- Gross profit margin
- Net profit margin
The reason why you need to keep track of both is because depending on the type of business you’re running gross profit margin won’t give you the full picture of your business. There are expenses and payments that are paid from the gross profits.
After everyone and everything has been paid, the leftover profit will be the net profit margin. If the margins are too tight then it might be necessary to raise your prices or cut costs. Now, let’s go over each one in more detail.
Gross Profit Margin
When talking about gross profit margin (GPM) business owners are normally thinking of a specific product or service rather than the entire business.
This is because pricing decisions and product line changes are dependent on the profit of each individual product or service and not on the business as a whole. If the gross profit margin of a specific product is too low then it’s possible there’s a problem with the supply chain of that particular product.
The business might need to find a new manufacturer for the product.
Let’s calculate GPM:
GPM = Sales Price – Cost of Good Sold
Here’s a quick example:
You have a shirt that costs $8 to manufacture and you sell that shirt for $24.
Gross Profit Margin = $24 – $8 = $16
GPM = ($24/$16)x100 = 150% or $16 dollars.
Calculating this might seem confusing at first but after you do this a few times every time you add a product into your catalog it will make sense naturally. Next, we’re going to talk about net profit margin and how to calculate it.
Net Profit Margin
Now we’re looking at the health of a business as a simple percentage. If your net margin is high then your business is healthy but if it’s low then something in the business needs to change.
If you net profit margin (NPM) is low it can be for these reasons:
- High overhead costs (Rent, office supplies, salaries)
- Too many monthly fixed expenses
- High transaction fees
Calculating net profit margin is very similar to gross profit margin but the biggest difference is that you’re looking at all of the company profit rather than a single product or service.
Let’s calculate NPM:
Net Profit Margin = Total Gross Profit – Total Expenses
Here’s a quick example:
Net Profit Margin = $10,000 – $5,000 = $5,000
NPM = ($5,000/$10,000) x 100 = 50% or $5,000
This number is the ratio of the margin to the total revenue. And it’s important to track this because you don’t want a low ratio between your profit and total sales because it means you’re spending all of your money and close to breaking even.
How Profit Margin Affects Business Decisions
Thankfully, in the United States profits are not taxable for any type of business because the income that each individual person takes home from the CEO to the last worker is taxed.
The profit margin allows business to experiment with new products and services that they otherwise wouldn’t be able to test if there wasn’t any money left over after expenses. A healthy profit also allows for employee incentive programs like Christmas bonuses, sales bonuses and paid maternity leave.
If a product or service doesn’t create a profit then there’s no incentive for a business to continue offering that product or service because it won’t grow the business. Margins are the main reason why certain jobs become automated or outsourced.
It’s also common to have set standards with margins. For example, if you’re selling a product online then it’s standard practice to set your price at 3x cost at a minimum. That means if the cost of the product is $5 then at a minimum it should be sold for $15 because the business needs to account for shipping, transporting, taxes and salaries that went into the product.
Wrapping This Up…
A healthy profit is what keeps a business going for years and makes sure that if there’s a slowdown in sales the business could survive.
Every day entrepreneurs are working and adjusting their strategies to grow their business and make sure they have the ability to expand and offer more benefits to their customers.
And all of that is made possible because a smart business owner takes ownership over their business profitability.