What are Profit Margins? Small Business Financial Guide
This financial guide will explain what are profit margins, their significance, and how to optimize them for your small business.
Keeping track of your finances is essential to running a successful business and evaluating your performance. Calculating your profit margin is one of the most important steps, as it’s an indicator of how profitable your business is. This number will give you an idea of how well your company is doing relative to the industry it’s in.
Without knowing how your business is doing profit-wise, it’s difficult to know where to make changes or when you should try to expand. Our guide will break down everything you need to know about profit margins so you know exactly which financial components to stay on top of.
A company’s revenue, or sales, is the amount of income generated before any expenses are accounted for. Cost of goods sold (COGS) is the cost of creating the product. COGS covers wages and the price of raw materials, but it does not take into account taxes or overhead costs. Overhead costs are ongoing costs that are not directly associated with product creation. Examples include rent, insurance, marketing, law, repair and utilities fees.
Once you have your revenue and COGS values, you can calculate your gross profit margin percentage with the following gross profit percentage formula:
If it takes you $100 to create a product, and you generate $1000 in sales, your gross profit margin would be 90%. This number tells you what percent of profit you are keeping after the manufacturing costs. Keeping track of your gross profit margin for each product gives you a detailed view of the profitability per product. However to evaluate overall financial health, you will want to calculate your net profit margin.
To calculate your net profit margin, you’ll first want to calculate your net income. Net income is defined as your revenue minus COGS, operating expenses, interest, taxes, and any other overhead costs. Unlike the gross profit margin, it takes into account all expenses.
Net income also includes any money gained from investments or other sources that doesn’t show up in the revenue from sales. Once you have your net income, you can calculate the net profit margin using the below net profit margin formula:
Your net profit margin shows you what percent of your revenue actually translates into a profit once all expenses have been accounted for. It’s a measure of the business’s overall profitability and ability to turn income into profit. This number helps you, or potential investors, determine if enough profit is being generated from sales.
These percentages give you insight into your business’s financial health. Low profit margins indicate that something is potentially off with your product pricing, deals with vendors, internal processes or other ways you are spending money in order to generate sales. For example, if you find that your gross profit margin for a particular service is quite low, you’ll know to consider removing that offering.
If your gross profit margin is high but your net profit margin is low, it could be a sign to cut on operating and overhead expenses. You don’t want to assume a business is in good financial health just because of increasing revenue numbers. If revenue is growing, but the net profit margin is decreasing - it means that operating costs are increasing too fast for the business to keep up. The business might have expanded too quickly by renting a new space or hiring more people.
All of this probably leaves you with the question - what is a good profit margin for a small business? The answer depends on several factors, including the industry your small business is in. If you give at-home childcare services - you’re likely to have higher profit margins because of the low operating costs. You don’t have to pay for facilities or inventory. Maybe you only take into account transportation costs and taxes for your expenses.
Therefore you shouldn’t be comparing your profit margins to a restaurant or law firm. This table, adapted from Camino Financial, gives guidelines on average profit margin for small businesses in a few industries:
According to the Small Business Development Centers association, a 20% net profit margin is good, 10% is average, and anything below 5% is when you should try to pinpoint problems.
Another factor to note is the size of your company. Often, newer businesses in the manufacturing and service industries will have higher profit margins to begin with. Later, as sales increase, the amount of people they need to hire increases as well. Other operating costs associated with production may also increase. That’s when mature businesses often see profit margins fall.
The first step to improving your profit margins is to keep your finances organized. To increase your profit margin, you’ll need to keep track of how your business is spending money and where you’ll be cutting costs. To organize small business expenses, we recommend Quickbooks, an accounting software geared towards small and medium businesses. If you use Hatch Business Checking, you automatically receive 50% Quickbooks for 6 months with Hatch Perks.
Once you know your expenses, here are additional ways to increase your profit margins:
You should calculate your profit margins on at least a quarterly basis. This way, you’ll regularly have insight into the profitability of your business processes and when you need to improve something.
With a dedicated Hatch Business Checking account, you can easily track your expenses, sales, and also transfer funds. Our modern, online platform for small business can help you organize your finances and calculate your profit margins regularly. Unlike traditional options, Hatch also eliminates NSF fees, offers cashback rewards on eligible debit card purchases, and has small business perks to help you grow. To find out more, click here.