Starting and running a business can be very exciting. It takes a lot of hard work but it may be worth it after all is said and done. After all, you work for yourself, which means you don't have to answer to anyone (other than your customers) and are often able to set your own hours. If you play your cards right and you're able to launch a great idea, you'll be able to see the profits grow.
Although money isn't always everything, it's certainly a top priority for people who are first starting up in the business world. Sure, you can tellyour vendors, investors, and loan officers that you want to make a difference in the world but there's a very good chance that they'll want to see more than just your good intentions. In fact, they'll probably be more interested in financial metrics, especially yourprofit margin.
If your business is new, there are several factors to consider before developing a sense ofyour ideal profit margin. We look at some of the basics of what you should consider when you're measuring profitability and studying your profit margings.
Key Takeaways
- Profit margins are financial metrics that are used to measure a business or company's profitability.
- A gross profit margin can be used to determine a particular item's profitability, but net profit margins are a better measure of overall profitability.
- The net profit margin is key as it measures total sales, less any business expenses, and then divides that number by total revenue.
- The best net profit margin for your business depends on what industry you're business is in, which means you shouldn't compare your margins to companies in other industries.
- Newer companies may have better profit margins than older ones because manufacturing costs increase while sales increase.
What Is a Profit Margin?
Before we do anything else, let's do a refresher on profit margins. The profit margin is among the most common profitability ratios that show how businesses make money. Put simply, the profit margin represents the total percentage of sales that result in a profit. Keep in mind, that you have to subtract all the expenses that go into running the business in order to get the resulting profits. A company's profit margin tells interested parties (investors, creditors, and others) how well handles its money.
There are several types of profit margins. But here, we'll look at two of the most common: the net profit margin and the gross profit margin.
Net Profit Margin
A company's net profit margin is commonly simply called the net margin. This margin measures profit (or net income) as a total percentage of revenue. Like other margins, net profit margins are expressed as a percentage. But in some cases, you may see them reported in decimal form.
Here's how you figure out the net margin for a business. Take the company's total sales and subtract the total business expenses incurred. Divide the result by the company's total revenue. So if your new business brought in $300,000 last year and had expenses of $250,000, your net profit margin is 16%.
Net margins allow companies (and others) to see how well their business models are working and to measure their overall profitability. They are also used to help devise profit forecasts, which is especially useful for individuals who invest in public companies.
Gross Profit Margin
The other most common type of profit margin used in the corporate world is the gross profit margin or the gross margin. It is calculated by subtracting the cost of goods sold (COGS) from a company's net sales. The result is then divided by its net sales. Like others, gross margins are commonly expressed as a percentage.
Investors, analysts, and management can use gross margins to determine a company's financial health. Major shifts in gross margins may indicate that the company needs to make changes to the way it's being managed. Or it may signal that the company's products and services may need to be reviewed.
Small business owners use the gross profit margin to measure the profitability of a single product. If you sell a product for $50 and it costs you $35 to make, your gross profit margin is 30% ($15 divided by $50). Gross margin is a good figure to know, but probably one to ignore when evaluating your business as a whole.
Operating profit margin indicates the amount of profit a company makes per dollar after factoring in certain variable costs, such as labor and materials. But this metric doesn't factor in taxes or interest. In order to calculate operating margins, you should divide the total operating income by the company's net sales.
The Industry Makes a Difference
Profit margins are very dependent on the industry in which a business operates. Business owners make a higher margin in some sectors compared to others because of the economic factors of each industry. That's why it's important to keep the industry in mind (in addition to the business size) when you're comparing the profit margins of any company with others. Put simply, you have to make sure that you're making an apples-to-apples comparison.
Let’s say you own a bakery and you make some of the best wedding cakes in town. You kept really good records and, after doing the math, came up with a net profit margin of 21%. But your friend owns an IT company that installs complicated computer networks for businesses and has a net profit margin of 16%. Does this mean you're a better business owner because your profit margin is five percentage points better? No. It doesn’t work that way as the profit margin is industry-specific.
Similarly, you may expect margins of 19.8% as an accountant. If you’re in the foodservice business, you might only see net margins of 3.8%.Does this mean you should sell your bakery and become an accountant? No. Profit margin doesn’t measure how much money you will make or could make, only how much is actually made on each dollar of sales.
If you’re a consultant, your margins are likely quite high since you have very little overhead. You can’t compare yourself to a manufacturer who rents space and equipment and who must invest in raw materials.
Net profit margins vary by sector and can't be compared across the board. By nature, industries in the financial services sector, such as accounting, have higher profit margins than industries in the foodservice sector, such as restaurants.
Profit Margins of New vs. Established Companies
Many new business owners generally expect a lower profit margin in the early years of their operations. It's not that they want to rake in lower profits. Rather, they believe that it takes time, effort, and a lot of money to start a business so making a profit may take some time.
Of course, when you begin earning a decent profit margin and how much you earn sometimes depends on your field. But in other cases,that’s surprisingly not true. Some businesses are prone to higher margins than others. Those with lower margins often have higher overhead and more expenses to pay. Consider business owners in the foodservice industry, which have to consider inventory, rent, utilities, and labor. But the goods and services they offer are often easier to sell.
In some cases, there's an inverse relationship between profit margins and sales. For instance, profit margins in the service and manufacturing industries decrease as sales increase. Businesses in these sectors may see a 40% margin until they hit around $300,000 in annual sales. That’s about the time when the business has to start hiring more people. Each employee in a small business drives the margins lower.
What Is a Good Gross Profit Margin?
There is no definitive answer to this question. That's because profit margins vary by industry and business size. Some sectors have, by nature, higher profit margins. This means that a high gross profit margin for a company in one industry may not be good for a company in another sector. High gross profit margins tend to be associated with manufacturing companies while those that buy and sell prepared goods, such as grocery stores, tend to have lower gross margins.
What Is a Good Gross Profit Margin Ratio?
A company's gross profit margin ratio compares the company's gross margin to its total revenue. It is expressed as a percentage. So if the ratio is 25%, that means that the company's gross profit margin is 25 cents for every dollar in sales.
Higher gross profit margin ratios generally mean that businesses do well at managing their sales costs. But there's no good way to determine what constitutes a good gross profit margin ratio. That's because some sectors tend to have higher ratios than others. So it's not a one-size-fits-all approach.
What Are Good Gross Profit Margins for Various Major Industries?
NYU's Stern Business School releases sector-related data on a regular basis. According to the school's margin report from January 2022, the average gross profit margin for education companies was 47.9%. Machinery companies saw gross margins of 35.4%, while real estate developers saw margins of 28.9%. Oilfield services and equipment companies saw gross margins of 7.9%, and air transport companies raked in gross margins of 1.4%. Financial services saw some of the highest, including regional banks at 99.8%.
What Is a Good Profit Margin for a Small Business?
The profit margin for small businesses depend on the size and nature of the business. But in general, a healthy profit margin for a small business tends to range anywhere between 7% to 10%. Keep in mind, though, that certain businesses may see lower margins, such as retail or food-related companies. That's because they tend to have higher overhead costs.
The Bottom Line
In the beginning, when a company is small and simple, margins will likely be quite impressive. You don’t have a large workforce and othersubstantial overhead expenses. As your sales increase and your business grow, more money comes in. But your margins will likely shrink because you’re probably hiring more people, investing in bigger facilities, and expanding your product line. Simply bringing in more cash doesn’t mean you’re making a bigger profit.
And as your business expands, continue to tend to its margins. Larger sales figures are great, but make sure you're earning maximum money on those sales.
