In addition to pursuing your passion, making a profit is the most popular reason to start a business. So, all business owners know they need to pay attention to their profits, and calculating profit is simple.
- Profit = Total Revenue - Total Costs
Simply tracking profits, however, can be quite deceiving because profits do not necessarily signify profitability. Consider two imaginary companies, a large appliance repair business and a small appliance repair business.
In a year, the large business generates $1,000,000 in revenue and the smaller company brings in $500,000. Respectively, they have $900,000 and $400,000 in total expenses, leaving them both with the same profit: $100,000. Both businesses made $100,000, but was the large company as profitable as the small company?
No, because the large company had to spend more to generate the same profit as the smaller company. This concept is at the heart of profit margins, which expressed as a percentage, reveal how profitable a business truly is.
Gross Profit Margin vs. Net Profit Margin
Gross Profit Margin
The gross profit margin expresses gross profits (total revenue minus your cost of goods sold) as a percentage of revenue. This is the best way to measure the profitability of your business or of individual jobs. Your company's profits might be increasing, but if expenses are also on the rise, your gross profit margin could be shrinking. If you only track gross profits, you won't notice this downward trend.
- Gross Profit Margin % = (Gross Profit / by Revenue) x 100
In our above examples, the small company has a gross profit margin of 20% and the large company's gross profit margin equals only 10%. This renders the larger company much more vulnerable to any fluctuations in its expenses, sales or an economic downturn.
Net Profit Margin
The net profit margin expresses net profit (total revenue minus cost of goods sold and operating expenses) as a percentage of revenue. The net profit margin can lend insight into operational concerns or expense issues which might be lowering margins and curtailing growth.
- Net Profit Margin % = (Net Income / Revenue) x 100
For example, our larger business likely has much higher operating expenses than the smaller company. Consider what would happen to their net profit margins if these business owners decide to increases employee compensation. If the larger company has 1,000 employees and the smaller company has 100 and they each give a employees a $0.25 raise, the large company's operating costs will increase ten-fold over the smaller business's, drastically affecting profit margin.
Don't Overlook This Unsung Hero: The Contribution Margin
Many business owners neglect the contribution margin, which is a company's revenue after all variable expenses have been subtracted.
- Contribution Margin = Total Revenue - Variable Costs
The contribution margin can also be expressed as a percentage of total revenue.
- Contribution Ratio = (Contribution Margin / Total Revenue) x 100
The contribution margin represents the revenue which contributes to your company's costs after reaching its break even point (the revenue needed to cover your fixed costs or cost of goods sold). Although it is not a profit margin, exactly, the contribution margin reveals your company's ability to grow, reinvest income or to generate profits.
Finding the Perfect Profit Margin
What profit margin should your business have? That's a good question. Healthy and acceptable profit margins vary greatly. While a 3% margin might be feasible for one business, the same margin would put another out of business.
Some companies might achieve margins upwards of 50%, while others only dream of soaring into double digits. Your company's ideal profit margin depends on several factors including the type of business, its size, location and several other items that are specific to different industries.
The best way to determine a healthy profit margin is to look at other businesses in your industry. Although direct competitors might be reluctant to reveal their numbers to you, you can access this information in several ways:
- Join trade associations and read reports from trade groups in your industry.
- Attend industry conferences.
- Research online.
- Ask your vendors about your competitors' activities and numbers.
- Your CPA or other financial advisors should be able to provide insight.
Two Approaches to Increasing Profit Margins
Two primary factors affect your company's profit margins: your prices and your costs. Not charging enough for your services or products and/or forgetting to "trim the fat" will inevitably stunt your profit growth, reducing profit margins.
The following two strategies to increase profits appear basic, but the methods your company might use to accomplish these two seemingly simple goals can be quite complex.
1. Raise Prices
The first solution most business owners jump to when the company does not generate ample profits is to raise prices. When your costs remain the same and your revenue increases, your profit margin will go up.
If, when you truly analyze your company's job costing and cost of goods sold, you realize your prices are too low, then you should by all means charge a fair price for your services. Price increases, however, should be considered with great caution, market research and consideration.
Disappointing profits, alone, are not a viable reason to hike prices. After all, when you raise prices, you risk overcharging, driving away customers and diminishing sales. With an optimized pricing structure, you can maximize profits and sales.
2. Reduce Costs
You can also effectively increase profit margins by reducing your costs. This includes both direct and indirect expenses. Seriously scrutinize every cent that leaves your company's accounts. Is it an absolutely essential expense or could it be reduced?
You can also consider your business processes, evaluating your company's unit economics to determine where time is wasted or if any redundancies occur to optimize operations for minimal costs.
Why a Dollar Saved Beats a Dollar Earned
Although at face value it appears to be worth the same amount, the money you bring into your company is not equal to the money you keep in your company – at least not with respect to profit margins. Increasing profits due to reduced expenses will increase your profit margin more than raising prices to increase profits by the same amount.
For example, consider the appliance repair companies from before:
- If the smaller company increased prices, earning an additional $20,000 in revenue, it would have total profits of $120,000.
- Profit Margin = ($120,000/$520,000) x 100 = 23%, a three-point increase over its original 20% profit margin.
- Now, if the company reduced costs by $20,000 to $380,000, it would achieve the same $120,000 in profits, but total revenue would remain the same.
- Profit Margin = ($120,000/$500,000) x 100 = 24%, a four-point increase over its original 20% profit margin and one point more than price strategy method.
As you can see, when it comes to profit margins, saving costs increases your profit margin at a higher rate than raising prices.
Strategically Optimize Pricing and Cut Costs with Management Accounting
With a smart back office, delivering thorough and accurate financial data, you can monitor your company's profits, profit margins and profitability, while also tracking invaluable key performance indicators.
With comprehensive financial data at your fingertips, you can make savvy decisions that will cut your company's costs and optimize your pricing structure to maximize profit margins and profitability.