Commentary is rampant about business failing or a very small portion of it being profitable. The discussion then pivots to how to continuously track the health of the business and that needs to be measured against an entrepreneur’s initial investment, or a return on investment. As great as these recommendations sound, they’re not that practical. At the end of the day, what matters is profits and profit margins. Business owners need to know how to calculate profits and the profit margin formula.
Although many may be content with a good understanding of how to calculate profits and why certain components need to be included, understanding the profit margin formula will result in much more insight. For starters businesses should know that there are many variations to the profit margin formula and each variation reveals a distinct set of performance metrics, all equally important.
Ultimately, entrepreneurs may have already learned this through experience, that having great profit margins is very different from having a great business. Sometimes there are specific areas businesses need to invest in and sacrifice margins for. Decision-making is made easier once we understand empirically how much the tradeoff is.
What is Profit Margin?
The profit margin is the amount represented as a percentage of how much a profit a business, a product or a service makes. A higher profit margin denotes a business, product, or service that is very profitable and vice versa.
More simply, the profit margin is a representation of the cents a business makes in profit for every dollar of sale. So a 20% profit margin means that for every dollar of sale the business recorded, it made $0.20. there are many different variations of profit margins, the most common profit margin is the net margin, one that deducts all expenses in deriving the net income figure.
Why do you need the profit margin formula?
There are a lot of benefits of calculating and using the profit margin formula. The profit margin lets you:
- Measure how profitable a business or a specific activity or product is. Once businesses understand that which product or activity generates the most profit margin, businesses can price their products and services accordingly. They may also choose to shed certain divisions depending on their margins and how those margins may compare to industry peers. All in all, profit margins help owners make smart decisions about their business.
- Share Profit margins details with Creditors. It is an important figure for most lenders who will require a business to share these details to better gauge performance. The more information available the better, so businesses should be able to showcase details about profit margins by business product or service, as well as various types of margins, discussed in further detail below.
- Monitor trends and benchmark performance – profit margins can let businesses quickly see the impact on margins of key components. You can easily see from the breakdown that there is a decrease in profit margins resulting from the changes in specific costs. Further exploration may reveal that those changes are a result of either price change, rising due to inflation, or falling due to the use of an inferior product. It could also mean the changes in costs may be driven by an increase in volume, possibly wastage or theft.
There isn’t only one type of profit margin formula
There are three main types of profit margin formulas; gross profit margins, operating profit margin, and net margin. The margins are reflected by the following hierarchy;
Gross Margin – a company generates sales for which the company has paid direct costs, referred to as the Cost of Sales or Costs of Goods Sold (COGS). Backing out those COGS from the sales revenue results in the Gross Profit. The gross margin is the gross profit divided by the sales revenue (Gross Profit / Sales Revenue).
Operating Margin – From there, other indirect costs necessary to keep the business operating are deducted. These costs are known as the operating expenses and include items such as advertising, marketing, phone, and utility bills among much other selling, general and administrative expenses. Further deducting operating expenses from the gross profit results in the Operating Income. Dividing this calculated operating income by the sales revenue results in Operating Margin (Operating Income / Sales Revenue).
Net Margin – The last type of profit margin formula is the Net income margin which simply calculates the taxes payable on the operating income. Backing out the taxes payable from the operating income, you can derive the Net Income. Net Income divided by the Sales Revenue results in Net margins (Net Income / Sales Revenue).
There is more to a business than simply the profit margin formula
It is important to understand the profit margin is a metric. It’s an important metric and one that is requested by various investors and creditors. However, it is not a panacea. Business owners will still need to make specific decisions that are often hard. That may include shutting down or divesting business lines that offer low-profit margins. Alternatively, it may also mean that owners are forced to keep a low-margin business running as it is a supplement to other, more profitable lines of business.
Also, profit margins are very nuanced. The profit margins of Facebook are not comparable to those of Amazon’s retail business. One business is not as capital intensive and leverages a large portfolio of intangible assets to drive profitability, whereas, the other is very capital and fixed assets intensive, requiring high volumes to earn low-margin profitability.
Although there are many opinions on why businesses fail and how to best monitor the health of a business by keeping track of specific benchmarks, one of the best practical advice to follow is to learn the profit margin formula. The profit margin formula is important because it helps look at multiple performance aspects of the business by offering different variations of the calculation. Finally, entrepreneurs can focus on the business itself once they understand what is important to them and to how much they are willing to pay for the important stuff.
The profit margin formula is the ultimate decision-making tool that helps business owners run their business more successfully based on an empirically financial assessment.