Profit margin sounds like a fancy word, doesn’t it? Don’t worry, it’s not as intimidating as it sounds! Your profit margin helps you understand the profitability of each of your products and services AND your business as a whole. Knowing this information helps you make better pricing and spending decisions and ensures you have a sustainable business for years to come.
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What is Profit Margin? (1:47)
I have to explain this in two parts. First, what’s profit?
Profit, also known as net income, is what’s left in your business after your business pays for its cost and its expenses.
Here’s the thing about profit – it’ll fluctuate over time. You can’t just look at your numbers once and believe that your business is profitable. Instead, you’ll look at your profit on an ongoing basis to check if and when your business is profitable.
Now, onto the profit margin!
Profit margin is a measure of how profitable your products, services, or business is. This number is expressed in a percentage which is a portion of your total earnings that you keep in your business. If your profit margin is 20%, that means that 20% of all the money you make stays in your business. It doesn’t go out to cover costs or expenses.
As small business owners, we typically think about our profit as what we’re going to use to pay ourselves. The higher the percentage, the more money there is that stays in your business and that you can potentially use to pay yourself.
There’s no official good or bad profit margin. It’s is super unique to the type of business you have, the industry you’re working in, and your business goals.
For example, you may not be focused on being profitable in the first year of your business because you’re putting money back into building your business. In this case, you’re not looking for a high profit margin. But, maybe a few years down the road, you’re focused on profitability and want to increase your profit margin.
There are two types of profit margin.
Gross Profit Margin
The first is called gross profit margin and it refers to the profitability of your products or services, in other words, the profitability of whatever you sell to make money. When calculating your gross profit margin, you don’t include your overhead costs. You’re only looking at what you’ve earned from your products and services and your cost of goods sold (also known as your direct costs).
Gross profit margin is used when determining your pricing and assessing your production costs.
Net Profit Margin
The second is net profit margin, which is where we look at the profitability of your business as a whole. Basically, how well does your business turn sales into profits?
Here’s where we include your operating costs. You may also think of these as your tax deductions. Basically, all your expenses that aren’t directly related to the production of what you sell or do.
Net profit margin is useful when you’re creating business budgets and reviewing your revenue model.
Calculating Profit Margin (8:12)
You can calculate your profit margin for any given time period, such as last month, last year, last quarter, and this year to date. The time frame that you choose is based on what information you want to know about your business. At the very least, you should calculate your profit margin on a yearly basis.
Gross Profit Margin Formula
Total Sales – Cost of Goods (aka Direct Costs) = Gross Profit
(Gross Profit / Total Sales) x 100 = Gross Profit Margin
Tune into the video at the 10: 00-minute mark to see an example that I provide with real numbers. Here’s the calculation that I explain based on an enamel pin maker:
- Total Monthly Sales = $5,000
- Cost of Goods Sold (aka the costs they incur to produce their pins monthly) = $2,000
- $5,000 – $2,000 = $3,000 (Gross Profit)
- $3,000 / $5,000 = 0.60
- 0.60 x 100 = 60% (Gross Profit Margin)
In our example, the pin maker’s gross profit margin is 60%. In other words, 40% of the sales of their pins goes towards producing the pins. Only 60% of every pin they sell stays in their business.
Net Profit Margin Formula
The formula for the net profit margin is similar, except now we also include operating expenses.
Total Sales – Cost of Goods – Expenses = Net Income
(Net Income / Total Sales ) x 100 = Profit Margin
Again, let’s use our enamel pin maker as an example:
- Total Sales = $5,000
- COGS (Cost of Goods) = $2,000
- Operating Expenses: $1,000
- $5,000 – $2,000 – $1,000 = $2,000 (Net Income)
- $2,000 / $5,000 = 0.40
- 0.40 x 100 = 40%
While they have a 60% net profit margin, that only includes the costs of producing the pins. When they start adding in their overall business costs, their profit margin decreases from 60% to 40%.
Looking at gross and net profit margin together helps you spot trends in your business. You see where you’re profitable and where you’re losing money. It’s like a compass that tells you which direction you need to pursue in order to maximize your profits.
Using Your Profit Margin (14:32)
Tune into the video at 14:44 to see how I use the Profit Margin Calculator to calculate profit margin and test various ways to increase your profit margin. .
To increase your gross profit margin you’ll need to increase your total earnings (which could be an increase in price or an increase in sales) or decrease your cost of goods sold. Depending on your business, you could do both or either. The spreadsheet will help you play with the numbers to see which avenue is most realistic for your business.
To increase your net profit margin, you either need to increase your revenue, decrease your costs, or decrease your operating expenses, or a combination of the three.
It’s time to put that profit margin calculator to work and I’ve created it just for you so you can skip the math and go straight to the strategy! Go ahead. Give it a whirl!