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Calculating your business's profit margin is a useful way to measure the balance between your revenue and costs. It's also a good external reference when comparing your business with other businesses in your industry. A “good” profit margin means different things for different industries; for example, advertising firms have an average net profit margin of 3%, while regional banks have an average net profit margin of 29%.
What is a profit margin?
A profit margin is how much of every sales dollar that your business gets to keep. For a simple example, say you have a lemonade stand. You buy bottled lemonade for $1 per bottle, and you sell it for $2 for a $1 profit on every bottle. Your profit margin is 50%. There are two types of profit margin:
Gross profit margin vs. net profit margin
That $1 profit on each bottle of lemonade, not taking into account any other expenses, is called gross profit. A 50% gross profit margin sounds adequate, and it may be. You may even think you’re charging too much. Before you cut prices, however, check out the other measure of profitability: your net profit.
Your business is likely to have numerous expenses beyond just paying for inventory. If you sell lemonade at a farmer’s market where you have to pay for a table, for example, you might be initially think that your business is doing enormously well if your sales greatly exceed however much you paid for your lemons and table. But after you pay your table fee, transportation expenses and so on, your financial picture may look very different. Ignoring costs that may not be so obvious is an easy way to result in a negative net margin.
How to calculate gross profit margin and net profit margin
Gross profit margin. The formula for your gross profit margin is: (Revenue - cost of goods sold) / revenue = Gross profit margin
This is the difference between your cost of purchasing or manufacturing the product (cost of goods sold) and revenue. You'll want to subtract your cost of goods sold from your revenue and divide the difference by revenue. The gross profit margin is often applied to one product or type of product at a time.
Using the example of lemonade bottles you buy for $1 and sell for $2, your gross profit margin is ($2 revenue - $1 cost of goods sold) / $2 or 50%.
You can determine the gross profit margin from total sales of 100 bottles of lemonade for $2 each, at a cost of $1 each, as follows: ($200 revenue - $100 cost of goods sold) / $200 revenue = 50%.
Net profit margin. The formula for net profit margin is: (Total revenue - cost of goods sold - other expenses) / total revenue = Net profit margin
Your net profit margin is similar to your gross profit margin, except your profit is reduced by all your expenses, not just cost of goods sold. The net profit margin is typically applied to total sales, instead of individual products. That’s because net profit margins include company-wide expenses and measure the total profitability of a business.
Using the lemonade stand as an example, say you sold 100 bottles of lemonade for $2 each, and you had $50 in other expenses. Your net profit margin is 25%, calculated as follows: ($200 revenue - $100 cost of goods sold - $50 other expenses) / $200 revenue.
Why do I need to know both gross profit margin and net profit margin?
Understanding gross profit margins and net profit margins helps you do the following:
- Predict feasibility of business or product lines. Knowing your gross and net profit margins, you may decide to eliminate less profitable product lines and concentrate on others. If you are considering a new business, you can use information about the gross profit margin and net profit margin to decide whether to go into the business.
- Determine how much you need to sell to make a net profit. Because some fixed expenses, such as rent, stay the same no matter how much product you sell, you need to reach a certain level of sales before you clear a profit. The amount of sales you need to make in order to pay your cost of goods sold and cover other expenses is called your breakeven point. You can also use your profit margin percentages to determine how much you need to sell to make any given amount of net profit.
- Use profit margin numbers for external partners and lenders. Obtaining a small business loan or any other form of business financing will require showing lenders that your business is in good financial health. You'll likely need to demonstrate profitability with both your gross and net profit margins.
What's a good profit margin?
How do you know if you have a good profit margin? A lot depends on the business you are in. Some industries operate with high margins; others have lower margins and must try to make a profit on high volume. It’s important to know the average profit margins in your industry.
For example, online retail businesses have an average gross profit margin of 46.69%, and net profit margins of 11.34%, according to the 2019 Operating and Net Margins Study by the New York University Stern School of Business. Grocery retail businesses, however, only have an average gross profit margin of 22.10%, and a net profit margin of 2.85%.
Here are some other average margins by industry according to the New York University Stern School of Business, January 2019:
|Gross Margin||Net Margin|
|Hotel / Gaming||54.32%||17.62%|
|Furniture / Home Furnishings||25.74%||2.20%|
|Restaurant / Dining||30.92%||12.11%|
If your profit margin is much lower than the average for your business, you may be charging too little, or your expenses are too high. On the other hand, if your profit margin is much higher than your industry average, that’s good news — until someone finds a way to undercut your prices.
A low profit margin is not always a bad thing. Some well-known individual retailers have surprisingly low profit margins. Walmart had a net profit margin of only 1% as of the reporting period ending Jan. 31, 2019. Walmart’s strategy is to sell a lot of products at low prices to make a return for their investors, which they do.
How to improve your profit margins
Now that you know the importance of gross and net profit margins, how can you improve yours? Here are three ways to begin:
- Reduce your cost of goods sold. If your profit margins are too low, you may need to find a less expensive source for your product or reduce your cost of manufacturing expenses.
- Find ways to cut other expenses. High payroll, rent, utilities and other expenses can kill your net profit margin, even if your gross margin is doing fine.
- Grow your business. The best way to improve your gross and net profit margins may be to increase sales. You may be able to buy or manufacture product more cheaply at a higher level. And higher sales will help cover your rent and other expenses even without raising prices, thus improving your net profit margins. Smart business owners keep an eye on their profit margins, but they also focus on expanding and improving their businesses as well.