What is a Good Profit Margin?
If you’re like most small business owners, you’re probably constantly looking for ways to cut costs and increase your revenue. But how do you actually determine the profitability of your business? By using the correct profit margin formula, you’ll be able to quickly get an accurate look at the state of your company finances.
We’re defining all of the important terms you’ll need to know and breaking down how to find out what your company profit margin is. If you don’t have a handle on the numbers you’ll need to use these profit margin calculations you may want to seek out an accountant to help. Then we’ll compare the profit margins in a variety of industries and give you some great tips on how your business decisions can improve your profit margin percentage and bottom line.
What is a profit margin?
Before we get started, it’s important that any small business owners understand what a profit margin is and what it means for their company. Essentially, a profit margin is a tool that you can use to figure out how profitable your business is and how efficiently your resources are being used, in the form of a percentage. The various formulas to determine your profit margins take into account things like revenue, cost of goods, and operating expenses. By plugging these numbers into the correct formula, business owners can understand how their net income relates to their overall revenue. In general, the higher your profit margin is, the more money your company is making.
Profit margin formula
Multiple different formulas can be used to determine the profitability of your company. Before we get into the specific equations and how they relate to your business, let’s take a closer look at the basic profit margin formula and what information you need to take from your income statement in order to calculate it.
Profit margin = (gross margin – expenses)
Gross margin refers to your earnings after the costs of production, including expenses like supplies, equipment, and labour. Expenses refer to the costs your company incurs after production and includes things like rent, employee salaries, and marketing costs.
When you subtract your expenses from your gross margin, you end up with a number that represents how much of the money your company made in revenue is being retained after all of your expenses.
Profit margin example
To help illustrate how the profit margin equation can be used in practice, let’s use a sample business and calculate their profit margin.
Your real estate construction company has a total revenue of $150,000 yearly. The cost of production-related goods, including building materials and equipment, comes to $50,000, making your gross profit margin $100,000. Your operating expenses, including paying your construction workers and real estate agents, rent, and taxes come to $40,000. Let’s plug those numbers into the equation to figure out your profit margin.
Profit margin = ($100,000 – $40,000)
Profit margin = $60,000
What are the different types of profit margin?
Depending on what specific information you’re looking for, there are a few different formulas for calculating profit margins. We’ll explain in depth what each equation is for and how to use them in your business.
Gross profit margin
Gross profit margin = ((revenue – COGS) / revenue) x 100
Cost of goods sold (COGS) includes any expenses associated with the production and manufacturing of your product, including all materials and labour. COGS does not include any costs to your business that occur after production.
The gross profit margin equation is often used by businesses to determine a single product’s profitability instead of the company’s overall profitability.
For example, let’s imagine that you design and sell mugs for $20, and they cost you $5 to make.
Gross profit margin = (($20 – $5) / $20) x 100
This leaves you with a gross profit margin of 75 per cent, meaning you retain 75 per cent of every dollar that you make after subtracting COGS, but not including operating costs after production.
Operating profit margin
Operating profit margin = (operating income / revenue) x 100
This formula considers all operating costs after production, including rent, salaries, and day-to-day company operations, to determine the percentage of each dollar that your business retains after all expenses (excluding any debt repayment, taxes, and non-operational expenses).
For example, you run a small business operating outpatient care centers. Your operating income is $60,000, and your revenue is $100,000.
Operating profit margin = ($60,000 / $100,000) x 100
According to the operating profit margins formula, you are retaining 60 per cent of your company revenue.
Pre-tax profit margin
Pre-tax profit margin = (pre-tax income / revenue) x 100
This profit margin measures businesses’ operating efficiency and profitability by showing what percentage of sales are turned into profits before taxes.
For example, let’s say that your auto detailing shop has a pre-tax income of $75,000 and yearly revenue of $150,000.
Pre-tax profit margin = ($75,000 / $150,000) x 100
Your pre-tax profit margin is 50 per cent.
Net profit margin
Net profit margin = ((revenue – total business expenses) / revenue) x 100
The net profit margin formula measures the profitability of your business as a whole.
For example, your handmade jewelry business makes $50,000 in revenue, and your expenses are $10,000.
Net profit margin = (($50,000 – $10,000) / $50,000) x 100
This leaves you with a net profit margin of 80 per cent.
What is a good profit margin for your business?
Now that you have a thorough understanding of the different types of calculations you can use to determine your profit margins, it’s time to consider what a good profit margin is. What makes a profit margin good has to do with a number of factors, like how successful your business is in its first year and how you deal with the growing expenses that come with business expansion. A good operating profit margin is also highly dependent on the industry you’re in, so don’t get discouraged if your profit margin is a lot lower than the average profit margins in a different industry.
Average profit margins by industry
Since the average profit margin for each industry is so varied, using research by the folks at IBISWorld, we’ve gathered up a shortlist of the most profitable industries in Canada according to their profit margins.
Primary care doctors: 55.4 per cent average profit margin
Physical therapists: 32.5 per cent
Dentists: 32.4 per cent
Real estate investment trusts: 46.5 per cent
Apartment rental industry: 37.4 per cent
Commercial Banking: 44.7 per cent
Law Firms: 43.8 per cent
Gambling: 36.5 per cent
HR consulting: 32 per cent
Management consulting: 31.7 per cent
If your profit margin isn’t where you think it should be, there are always ways to make it better.
Ways to improve your company profit margin
No matter how high your profit margin may already be, there is always room for improvement. Here are some ideas that you can implement in your small business if you want to boost your gross profit and see a higher balance on your income statement this year.
One of the best ways to increase your profit margin is by decreasing your operating expenses. That could mean eliminating overtime and adjusting your workflow, or it might involve negotiating with your vendors. Try to increase your order quantity to be higher than your vendors’ MOQ (minimum order quantity) in order to get access to better rates and savings. Just make sure that if you’re looking for ways to cut costs, you don’t compromise on the quality of your offers.
Increase perceived value
Take a look at other businesses in your industry to see the different levels of value and how they are marketed. You may notice that by presenting your offer as high value and using a marketing language that focuses on how your business improves your customer’s lives, you’re able to demand a higher price for what you’re selling. Start by looking at the pricing of your top-selling products, raising where you can, and if it works you can slowly adjust all of your products to be sold at higher rates. Tiered pricing options can also encourage buyers who purchase low ticket offers to convert into a mid- or high-level sale. Make sure that you are placing your most profitable products in high traffic, high visibility locations, whether your business is online or in person.
While offering sales is a great way to move inventory, markdowns ultimately mean that your profit margin is going way down. If you are looking for ways to avoid markdowns, put your efforts into improving inventory visibility and management.
Increase your average order value by upselling and cross-selling relevant add-on products or services. Encourage impulse buys at the checkout by offering special deals and promoting items that your customer might have missed, but your research shows that they are likely to buy along with what’s already in their shopping cart.
No matter what techniques you choose to explore to increase your operating profit, keep notes on how your promotions perform, and use that knowledge to inform future business decisions.
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This article offers general information only and is not intended as legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. While the information presented is believed to be factual and current, its accuracy is not guaranteed and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author(s) as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by Royal Bank of Canada or its affiliates.