Profit margin is a frequently used profitability ratio that helps determine how much money a company's business activity is bringing in after deducting the costs associated with its production. To put in simple terms, it highlights what percentage of sales has resulted in profits.
While this metric will vary depending on industry and location, many small businesses in the U.S. have surprisingly low profit margins. In fact, studies show that a typical North American small business only has an average profit margin of 7%. Meaning, most small business owners only take home 7% of their overall profits.
However, successful businesses regularly measure this metric to ensure this percentage is as high as possible without sacrificing customer satisfaction or quality to increase total profits. Simply raising the profit margin to 13% or above can boost businesses to the top 10% in the market. Therefore, it should come as no surprise that many creditors and investors depend on this metric to analyze a business's profitability and sustainability.
How to Calculate Profit Margins
For businesses trying to calculate their gross profit margins, they must first determine their cost of goods sold (COGS) and net sales. Determining the COGS will take into consideration all of the expenses associated with producing a particular item, such as raw material and labor costs, as well as other costs of doing business.
From then on, they can utilize the following formula-
Gross Profit Margin = (Net Sales COGS) / Net Sales
Part of understanding how to increase profit margins is in knowing the variety of factors that can influence this metric. Ultimately, every industry will be affected by economic conditions and market trends, which can influence customer behavior, interest rates, and costs of material, production, and labor. Therefore, management should keep a close eye on all of these factors in order to increase total profits.
5 Tips to Increase Profit Margins
Learning how to raise the profit margin of a company is vital to the bottom line and the business' capacity to attract investment. Investors frequently use a company's profit margin as an indicator of its capability to manage its expenses when weighing up a potential investment.
In this sense, investors will compare a business operating profit margin (dollar to dollar conversion of revenue converted into profit) to the entire industry or benchmark index such as the S&P 500, to gain an idea of a business' overall performance within the market.
Business owners wanting to improve their chances of acquiring funding or simply increase their total profits should consider the following 5 tips.
1. Increase prices - Increasing the prices of popular products is the quickest way to increase profit margins. However, management should remain cautious of taking this approach, as having price points too far above those of competitors can backfire as consumers seek more affordable options.
2. Reduce operating expenses - Streamlining operations to cut operating costs can be done in a number of ways. Businesses should begin by reducing excess staffing and overtime hours as much as possible without sacrificing the quality of service provided to consumers.
One simple way to lower labor-related costs is to automate repetitive and time-consuming tasks, such as business forecasting. Forecasting can require complex calculations and take up hours in a manager or owner's day. However, by utilizing software, businesses can make this process instant.
Management can also analyze the costs spent on inventory and whether the business can afford to minimize supply without stocking out of popular products.
3. Improve purchasing practices - Businesses should not be afraid of negotiating with vendors for a more affordable price. With regular suppliers, management should enquire whether discounts or other offers are possible.
However, if this isn't realistic, there is nothing wrong with scouting for more affordable vendors instead. Larger businesses can also increase their purchase quantities to lower the price of the individual item as long as they have the storage space available.
4. Eliminate bottlenecks - Manufacturing delays or other factors that slow down the sales process can increase costs. A slow inventory causes increased storage costs, a higher risk of spoilage, and increased potential for dead stock.
Observe supply chain procedures to make sure workers are equipped with the right tools to boost productivity and eliminate bottlenecks or inefficiencies that may cause delays in sales.
5. Reduce waste and spoilage - Reducing waste production is not only great for the environment, but also for controlling the costs of doing business. Businesses may be mistakenly ordering more inventory than necessary to meet demand, which can lead to excessive waste and spoilage. To prevent these issues, management should forecast future demand and sales and only stock what is absolutely necessary to optimize sales.
When accurately monitoring profit margins, it can be helpful to utilize automated data analysis through forecasting tools. Forecasting software can often integrate with the business' existing point of sale system to track incoming sales and business expenses in real time.
As a result, companies can access the most up to date and accurate profit margin percentages and sales projections to predict the financial health of their operations with minimal effort.