Every business exists to make money. Without doing so, the business will eventually fold up.
For example, in respect to tech companies folding up as soon as they are established, Farah K, a product marketing manager , writes why, having been in that industry for almost a decade. “Locally, internationally, small tech, big tech, bootstrapped startups, and VC-funded startups” are struggling to break even because they have refused to pay attention to profit margins, among other things.
“A guy I know is running a startup of 10 people with costs outrunning revenue by quite literally 100%. Now he’s chasing for partners and investors. A popular bus service company laid off dozens of people just 6 months shy of being recognized for getting the ‘highest’ rounds of VC funding.”
Farah’s finding isn’t limited to the tech industry alone. Many businesses and startups in other industries are also facing this challenge.
This makes it pertinent that every business owner pays adequate attention to their profit margin.
- Profit margin is the indicator of a business’ health and profitability.
- There are no fixed rules as to what constitutes a bad profit margin because profit margins vary from industry to industry.
- Strategies to increase profit margins include, reducing direct and operating costs, increasing sales or price, and increasing customer retention.
What is a Profit Margin?
Profit margin shows the amount of money your business retains for each dollar of sale. In other words, it shows the extent of your business’s profitability. The profit margin is expressed as a percentage. The greater the percentage, the higher the profits the business is generating. Profit margin is also an indicator of a business financial or fisical health.
What is the Gross Profit Margin?
A gross profit margin is the amount expressed as the percentage of revenue that is left after deducting direct expenses. Direct expenses are costs associated with producing the product or service. E.g. wages and raw materials.
How to Calculate Profit Margins
Profit margin is measured at three levels: gross profit margin, operating profit margin and net profit margin.
For example, if a business generates $5,000 in sales and its operating and direct costs are $1,500 and $1,000, respectively, the first thing to find out is the gross profit margin.
Gross Profit Margin= GP/Revenue*100
To find gross profit, deduct direct costs from sales.
$5,000-$1,000 which gives $4,000
GP/Revenue *100 gives the profit margin in percentage.
$4,000/5,000*100 = 80%
Operating Profit Margin
Operating Profit Margin = Operating Profit/Revenue multiplied by 100.
To get the operating profit, deduct operating expenses from gross profit.
Net Profit Margin
Net Profit Margin = Net Income/Revenue multiplied by 100
To arrive at the net income, taxes and interest, operating and direct costs are deducted from revenue.
Good Profit Margin and Bad Profit Margins
According to corporatefinanceinstitute.com, “a good margin will vary considerably by industry, but as a general rule of thumb, a 10% net profit margin is considered average, a 20% margin is considered high (or “good”), and a 5% margin is low. Again, these guidelines vary widely by industry and company size and can be impacted by a variety of other factors.”
Jim Larvato, founder of 4M performance, says it. “Depends on the business and industry you are in. If I’m in a grocery supermarket a 50% margin is unheard of – they usually work on margins below 5%.
“If I’m in the cosmetics industry 50% is low. They operate on 100–200% margins. Jewellery stores normally work on 500–600% margins.” Jewellery stores have high profit margins because their products are often sold at high prices.”
Strategies to Increase Your Profit Margins
A rising profit margin is an indication that your business is thriving. It also shows that you have learnt how to increase the amount of money coming into your business versus what is going out. Research shows that the following are some ways you can improve your profit margin.
Expenses should be monitored and tracked
Knowing the different forms of expenses, your business makes, and tracking them is critical for eliminating unnecessary costs. Direct costs and operating costs are two costs that impact the profit margin. To reduce direct costs, you can look for cheaper suppliers for your raw materials. However, care should be taken not to downgrade the quality. For example, the individual mentioned by Farrah.K whose costs were far in excess of his revenue could have cut costs by hiring fewer people, outsourcing some business functions, or hiring contract workers rather than full-time employees.
By monitoring and tracking expenses, you will be able to prioritise what you should spend on and what you can do without.
Increasing prices or sales
Increasing the price of your product will boost your revenue. However, there is a caveat: you may lose customers. If you can raise your price without losing too many customers, you can quickly increase your profit margin. If raising prices is not an option for your business, another good option to try is to increase sales. Upselling, cross-selling, collaboration and partnerships are some of the strategies you can use to increase sales.
Increase Customer Retention
Studies show that increasing customer retention is far more cost-effective at increasing sales than acquiring new customers. It will cost you seven times more to acquire a new customer than it will to retain an existing one. In fact, increasing the customer retention rate by 5% can increase sales by 25-95%.
In summary, whether you are a new business or an established one, you need to pay attention to your profit margin to remain in business. It is an indicator of your business’s financial health and profitability.