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Profit Margins: Is Your Business Running at a Reasonable Rate?

Small Business Profit Margins

Small businesses make up 99.9% of U.S. businesses and employ at least 59.9 million of the workforce, meaning their impact on the country’s economy can’t be understated. However, according to the U.S. Small Business Administration (SBA), 20% of small businesses fail in the first year, around 50% survive for five years, and only 33% stay operational after 10 years or longer. 

Although small businesses fail for various reasons, the most common is a lack of demand for the product or service, poor management, and cash flow problems. Therefore, your finances and your company’s profits should be a top priority. To get the best look at your profitability, you’ll want to know more about your profit margin — specifically your net profit and gross profit margin. 

In this guide, we’ll define what your company’s profit margin is and why it’s incredibly important for your small business. We’ll also explore how to calculate your profit margin to help you understand if your business is operating at a reasonable rate. Yes, there’s math involved, but not too much — promise!

What is a profit margin?

Profit margin refers to the percentage of income that remains after you’ve deducted your business expenses. As a business owner, knowing how to calculate your profit margin is important because it reveals your business’s financial health (is this actually a profitable business?) and serves as a barometer for your management skills and the effectiveness of your business practices (are we doing all we can to manage costs and make money?).

In the early stages of your business, you’ll want to use your profit margin to determine your pricing strategy for your product and/or service and what you need to do before you make any profits. If you’re a startup offering a new product, for instance, your profit margin shows how much you’ll need to sell before you can become profitable.

Profit margins are also important down the road if you’re looking for a loan. If you receive outside funding, you may need to calculate and report specific profit margins to lenders periodically as a requirement for securing their investment. 

There are a few ways to look at your profit margin. Below, we’ll take a closer look at net profit margin and gross profit margin and how to calculate both. 

Net Profit Margin

The net profit margin — generally expressed as a percentage — measures the profitability of your business. It’s one of the best ways to look at profit margins because it represents the business’s bottom line after accounting for all expenses. 

Knowing your company’s profitability will help you examine your expenses and take steps to lower costs where you can. For instance, say you’re the owner of a small construction company. You can calculate your net profit margin to determine if your operating costs are being utilized effectively and efficiently. Are you spending too much on overhead costs, like an unused office space? Are materials ordered as needed, or are you sitting on inventory for months before it’s used? Your net profit margin can help you answer these questions. Get it calculated, and keep it in mind!

Gross Profit Margin

Where net profit margin looks at your business’s profitability, gross profit margin measures the profitability of a single product or service provided. The higher your gross profit margin, the more efficient your ongoing operations are. 

As a small business owner, your gross profit margin allows you to track your cost or production efficiency and compare your performance to the industry’s average profit margin. You can also optimize your pricing strategy and decide how to charge for your service and/or product.

For instance, if you are a freelance writer who prices your services on a per-project or per-article basis, determining your gross profit margin on each will let you know which method is more profitable — this is incredibly useful knowledge. Deduct the cost of goods sold (CoGS) from your total invoice for the whole project and divide that figure with your total invoice again. Do the same with your total income and expenses per article. The result will tell you if it’s more beneficial to price your services per article or per project. (Don’t worry, we’ve got some examples of this calculation below.)

What is a good profit margin?

As a rule of thumb, a higher profit margin means you have your expenses under control, and your business is doing well. And although profit margins are a good metric to compare businesses regardless of size, other factors should be considered before a profit margin is deemed high or low. The age of your business, location, and industry, for instance, can play a role in your profitability.

If you have a lower profit margin, don’t sound the alarms immediately. Take a look at your expenses and cut costs where you can. You can also figure out if there are ways to increase your cash flow, like attracting new clients.

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How to Calculate Profit Margin

Remember that profit margins represent the percentage of your total revenue converted into profit after accounting for business expenses. As a formula, this looks like:

Profit Margin = Total Income – Total Expenses * 100
                                    Total Income

Note that even if you haven’t started generating revenue, it’s still a good idea to learn about profit margins because you can incorporate this knowledge into developing your business plan. Instead of using real numbers, you’ll want to use conservative estimates of your total sales and expenses. 

Below, we’ll help you calculate the net profit margin and gross profit margin for “Christina’s Cakes.” Christina creates custom cakes outside her 9-to-5 job and wants to know whether this side gig is profitable enough to turn into her full-time job. To help her decide, she looks at her books to come up with her different profit margins. 

She sold 15 cakes at a selling price of $400 per cake for total revenue of $6,000 for the year. It costs her $200 to make each cake, which would make her CoGS $3,000. She also spent $1,500 on various overhead costs, including new baking supplies and a business logo.   

Net Profit Margin Formula

To calculate Christina’s net profit margin, we’ll use the following formula:

Net Profit Margin = Total Revenue – (CoGS + Overhead Costs) * 100
                         Total Revenue

Start with her total revenue, which is $6,000. From there, you’ll want to subtract her total cost of goods sold and total expenses, which is $4,500. This is known as her net income.  Divide this total by her total revenue and multiply it by 100. Her net profit margin is 25%. 

Net Profit Margin = $6,000 – ($3,000 + $1,500) * 100 = 25%
                $6,000

Although net profit margin is industry-specific, Christina’s margin of 25% for a bakery would be considered high. If her net profit margin dipped to 5% or below, it would be considered low as a general rule of thumb, regardless of the industry. With a low net profit, she would want to improve her net profit margin by increasing her prices and selling more of her goods.

Gross Profit Margin Formula

To calculate Christina’s gross profit margin, we’ll subtract the cost of goods sold from her total revenue divided by your total revenue, as shown below:

Gross Profit Margin = Total Revenue – CoGS * 100
                                    Total Revenue

We’ll start with her total revenue of $6,000 and subtract the $3,000 for her cost of goods sold. We’ll divide that by $6,000 and multiply it by 100 for a gross profit margin of 50%.

Gross profit margin = $6,000 – $3,000 * 100 = 50%
                  $6,000

Looking at her net and gross profit margins, Christina’s business seems to be off to a great start and has the potential to become her primary source of income. She seems to have priced her cakes correctly, and with a new logo for her business, she likely won’t incur that cost again next year, so she should see an increase in her net profit margin for the coming year if everything else remains the same. 

If Christina’s gross profit margin had been lower, she might want to consider raising the prices of her cakes or looking to increase her number of cake sales.

Resources to Help Run Your Business

Profit margins may not be as exciting as picking out designs for your business name and logo, but you are highly encouraged to learn about them. Whatever your reason for starting a business, knowing your ideal profit margin will help you evaluate if your business practices benefit your bottom line. 

At ZenBusiness, we have a dedicated team to help you get your new business started. We strive to make business formation affordable and easy. ZenBusiness is prepared to help you every step of the way, from understanding what you need to stay compliant with state business requirements to taking charge of your accounting and bookkeeping. 

Profit Margin FAQs

What is a good profit margin for retail?

The retail sector, especially clothing and electronics retailers, is prone to high levels of business volatility. This is why retailers tend to have lower profit margins compared to other industries. According to the NYU Stern School of Business, the average gross profit margin for general retailers is 24.79% and a net profit margin of 2.44%

E-commerce or online-only retailers show the highest increase in profit margins, which currently sit at 45.25% and 4.57% for gross profit margin and net profit margin, respectively. 

How do I calculate profit margin?

Let’s review the two types of profit margins and how to calculate them:

  • Gross profit margin measures the percentage of profit a business generates after accounting for the expenses related to the production of an item or service. 

Gross Profit Margin = Total Revenue – Cost of Goods Sold * 100
                                 Total Revenue

  • Net profit margin measures the overall profitability of a business. 

Net Profit Margin = Total Revenue – (CoGS + Overhead Expenses) * 100
                         Total Revenue

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Is a high profit margin good?

Profit margins are generally regarded as the standard benchmark for measuring the profitability of a business. Therefore, a high profit margin is considered a good indicator that a business has growth potential. A high profit margin also establishes that the business manages its expenses effectively and succeeds in reaching its sales goals.

What is a bad profit margin?

Generally, a zero or negative profit margin is considered bad. If your profit margin is zero, you are just generating enough sales or income to cover your expenses. If you have a negative profit margin, you are spending more than what you’re bringing in as income. 

Remember that if you calculate a negative profit margin, don’t automatically throw in the towel for your business. Take a look at some of your operating expenses and financial statements to see where there is room to cut costs.

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