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A successful business has to make a profit. What that profit is, exactly, can mean something different for different entrepreneurs and online business owners—those who are just starting out won’t need the same profit as those who intend to scale.
To understand the financial health of your business, you need to calculate your profit margin. Your profit margin provides you with valuable insights that can help you make decisions about potential next steps.
If you’re a new entrepreneur or thinking about starting a business, let this be your profit margin calculation 101 guide. We’ll discuss what it is, how to determine a good profit margin and areas to improve, and give you a handy profit margin calculator for whatever your business needs.
Note: The contents of this article are for educational purposes and should not be construed as legal or financial advice. For questions regarding your specific situation, consult a trusted professional.
What is a profit margin?
It’s a good rule of thumb to make more money than you spend. It’s true in personal finance and it’s true for any business. A profit margin essentially tracks this part of any business operation. A profit margin is the percentage you make from every dollar of your sales. The higher that percentage, the higher your profit margins.
Depending on your needs, you may calculate gross or net profit margins. Gross profit margins focus on your profit after the cost of creating your goods, while net profit margins factor in the additional expenses of your business.
Why is it important to calculate a profit margin?
Profit margin calculations help you make better, data-informed decisions about what your business needs. The ability to accurately measure and predict your profit helps you with budgeting, vendor selection, and if you can—or should—open a brick-and-mortar location in addition to your online store.
Whether your business grows can be decided by these numbers. If profit isn’t marginally growing, or is slumping or remaining static, then chances are you’ll have to wait until you find some cost efficiencies.
Understanding the financial health of your business is paramount for its success. What you consider a success depends on your needs, the products you’re selling, and for how long. For new entrepreneurs and business owners, success in the first year may look like breaking even, and second- or third-year success may mean gradually increasing profit margins.
When do you need to calculate a profit margin?
Keep track of how your business is doing on a regular basis. What that cadence looks like is up to you. For net profit margin calculations, that can be done on a quarterly basis. To better understand the specific sales of some products, consider calculating the gross margin profit monthly.
Lee nuestra guía de finanzas para pequeñas empresas
Types of profit margins
There isn’t just one profit margin businesses can look at to understand their profitability. Generally, there are three types of profit margins business owners calculate for better insight into how well their business is doing.
1. Gross profit margin
The gross profit margin is calculated by subtracting the cost of goods sold (COGS) from the overall profit. COGS includes any raw materials needed for products and additional costs for the product, like labor (manufacturing or packaging and shipping).
Your gross margin profit for specific products or services helps you to understand how well they’re selling relative to the cost that goes into making them. If your gross profit is low or negative—when the price doesn’t cover the total cost of creating the product—then you may want to consider raising the price of a product or decide if it’s the right product to sell.
To determine what your gross profit margin is, use this calculation:
((Net sales - COGS) / Net sales) x 100 = Gross profit margin
Say you’re a small business selling print on demand (POD) t-shirts and your net sales are $10,000 but your COGS amount is $6,000. The difference is $4,000. From there, take that difference ($4,000) and divide it by the net sales ($10,000). This yields 0.40, and when multiplied by 100, is 40%. Your gross profit margin is 40%.
2. Operating profit margin
Calculating your operational profit margin is a lot like determining the gross profit margin, except that this amount takes into consideration all of the costs involved in running a business, not just COGS. This includes administrative costs—anything from the ink cartridges you need for a printer to software for processing sales. If you have a physical space, like a brick-and-mortar store, you’d factor the rent of it in here.
Operating profit margin shows the business’ profitability from an operating standpoint vs. purely on product sales, like with gross profit margin.
To calculate your operating profit margin, first you need to know your operating income. Operating income is your net sales before interest and taxes are taken out, also known as EBIT. In other words, your gross sales, minus COGS and any other operating costs.
To determine what your operating profit margin is, use this calculation:
(Operating income / Net sales) x 100 = Operating profit
Let’s use the same example of a print on demand t-shirt operation. Net sales are still $10,000 and COGS are $6,000. Your operational costs are $2,000, which means your total operational costs are $8,000. That leaves you with $2,000 in operating income. Divide that number by $10,000 (your net sales) and multiply by 100 to get a 20% operating profit.
3. Net profit margin
The last profit margin type is net profit margin, which calculates your revenue after incorporating every business expense, such as administrative costs, COGS, taxes, interest, and depreciation. Depreciation refers to the value of a business’ equipment or assets, like machinery or real estate, but often isn’t a factor for smaller businesses.
Your net profit margin is more colloquially called your bottom line. It’s how well the business is doing. It’s the closest possible number to give you (and any other interested party) an overall financial picture. For new businesses, this is a great metric to help you identify growth opportunities or where to reduce costs for future growth.
To determine what your net profit margin is, use this calculation:
((Net sales - COGS - operating expenses - taxes - interest) / Net sales) x 100 = Net profit margin
Let’s use the same example in this final profit margin type. For the POD t-shirt business, let’s say net sales, or revenue, is $50,000. The COGS amount is $18,000, operational costs are $6,000, tax is $5,000 and interest is $5,000. Net profit is $16,000. Divide that amount by the revenue and multiply by 100. The net profit margin for this example is 32%.
When is a profit margin good?
Typically, a good profit margin can sit as low as 5%, meaning a business isn’t spending more than it earns back, and can cover any operational costs with a little left over. A profit margin of 7-10% is a little healthier, and provides some buffer for unexpected or additional costs, or if some products or services aren’t selling as well as others.
However, if your business has a 20% profit margin or higher, this is excellent and can signal that the business may be ready to grow by hiring more employees or developing new products. It can also signal that the business has long-term staying power.
Some examples of low profit margin businesses include:
Restaurantes
Retail stores
Grocery
These businesses have high operating costs like rent, employees, products, and maintenance, which can cut significantly into their profit margins.
Some examples of potential high profit margin small businesses include:
Personal training
Accessories and apparel
Cursos en línea
Businesses like these have relatively low operating and production costs, and fewer recurring costs. That frees up more profit from each sale.
How to improve your profit margins
A good profit margin allows you to make at least some money back from your sales after everything is calculated. But the larger your margin is, the more you can put back into your business. If you’re looking to improve your profit margin, consider the following tactics.
Keep track of income and expenses
It’s essential to track every single dollar you spend on your business in addition to every dollar you make. Need a pen? Keep track of how much it costs. Switching vendors? Make sure you record what that cost is versus what you were paying elsewhere. Every amount matters, and regular reviews can help you identify places to reduce or change spending.
Consider where to create efficiencies
There are going to be ways for you to streamline processes and cut your spending in the business that may save you some money or provide you with more profit over time. This can include automating online ordering, buying materials in bulk, or reducing operating costs by reducing staff or physical space needed. This is also a place where changing vendors or shopping around can be beneficial.
Prioritize customer retention
Repeat orders are a gift to your business. Retaining customers will cost you less than trying to reach new ones. Stay on top of this by being customer-obsessed. 68% of entrepreneurs in a Squarespace survey noted that they use customer satisfaction to measure their success.
Track your repeat business and see if there are opportunities to provide them with more value so they keep buying from you, like discounts or a loyalty program. Understanding your customer and why they keep coming back can yield growth opportunities, too.
Read our tips for building customer loyalty
Invest in high-margin products
Investing some resourcing into high-margin products can boost your bottom line. What you sell has to remain aligned with your business needs and goals, but high-margin products will help you generate more profit, faster.
Consider what could fit your existing product line. Physical items like candles or POD products fall can be high-margin, but so are digital products like paid downloads, paywalled videos, memberships, and online courses.
Increase average order value
Average order value is the amount someone spends in one shopping trip in your store. You can make your products and pricing appealing to potential customers so they increase the amount they spend per order.
For example, you can sell product bundles with a slight discount or recommend related products while they’re shopping. Even with a discount, the value of those orders is higher than if they bought one product at a time.
Learn how to increase sales with cross-sell and upsell strategies
Let go of products that aren’t selling well
This is where a review of your net profit by product can be particularly helpful. Regularly reassess what’s selling well and what may be a low-margin product. You can track low-margin products over time to see if anything changes. But if you think marketing or product design won’t change sales, it may be time to move on. Put those items on sale to move inventory.