You are in business for a reason – to make money. Of course, you also want to offer products or services that provide value to your customers, keep your employees happy and you want to market your business to keep generating new customers. But the bottom line? You would not be in business if you did not intend to make a certain profit from all of your efforts.
Hence, one of the key accounting figures you’ll want to measure is called a profit margin. Mind that it’s not the same as profit. So, let’s take a look at this whole thing, and learn how to calculate gross profit margin for your business.
What is the Difference Between Profit and Profit Margin?
Let’s define both of these terms first.
Profit = Total revenue minus your expenses. For example, suppose you have a tattoo parlor. This year, you did $75,000 worth of business (total that customers paid you). Your expenses (rent, utilities, employee salaries, business license, supplies and equipment) totaled $48,000. Your profit (also called net revenue) is 75,000 minus 48,000, or $27,000.
Profit Margin= Measure of your Profitability. It is a figure of how much you keep in earnings from every dollar of sales you generate. The profit margin does not get measured in dollars, but, instead, in a percentage. To measure this, you divide your net income by the total amount of sales.
Taking the tattoo parlor as an example, your total sales were $75,000. And your net income was $27,000. You simply divide the 27,000 by 75,000. The percentage you get (in this case 36%) is your profit margin.
If you run a product business, however, you’ll may want to measure the Gross Profit Margin instead. The profit margin formula will look like this:
Gross profit margin = ((Revenue−Cost of goods sold)/Revenue) x 100%
So, for example, let’s say that you run a dropshipping business and earned $50,000 in revenues last year. Your COGS is $35,000, and your gross profit margin is 30%. So your business generates 30 cents in gross profit before paying out any business expenses. A higher ratio is often viewed as a general indication of the business’s profitability, but it’s not a conclusive measurement.
Why Do You Need to Know Your Profit Margin?
The profit margin figure really tells you how much control you have over your costs. For example, suppose your tattoo parlor increased its sales to $100,000. To get that increase, you added some staff, bought some new equipment, and put more into advertising. And suppose that additional money you spent added $20,000 to your operating expenses. So now your operating costs are $68,000, and your net income is now $32,000. Your profit margin (32,000 ÷ 100,000) is now at 32%, less than it was before you expanded.
Increasing your revenue is certainly a goal. You end up with more net money. But just increasing that revenue does not increase your profit margins. In the example above, you can see this.
Most small businesses believe that if they can just increase sales first, they will increase their profit margin. But controlling costs is actually the better long-term plan. When you control costs, you profit margin increases, and it will have a stronger impact on the health of your business in the long run. Why? Because it is usually easier to find ways to decrease costs than it is to increase sales and net profit.
What is a Good Profit Margin?
There is no magic number here. A good profit margin depends on the business niche, the time in business, and a lot of other extenuating circumstances (e.g., a business is undergoing a large expansion). Good retailer margins for SMEs are between 20-25%, although some industry averages can be as low as 11%, especially during an investment in growth. And this lower figure is even acceptable as a norm for some industry niches, if continued costs of producing a product or service will keep it competitive.
How to Increase Profit Margin: 5 Proven Tips
Remember, the profit margin percentage gives you a general view of your business’s health. And you want to get that margin as high as possible, because it ultimately means higher profits.
So, what can you do to increase that margin? Find ways to cut your operating expenses. Here are tips that will help you do just that:
1. Up- and Cross-Sell
The idea here is to sell more to a customer all at one time. This ultimately lowers your cost per sale, on those additional products or services that customer buys during this one-time interaction. Thus, overhead costs of multiple sales to that same customer are eliminated.
One way to do this is to provide a small discount for buying in bulk. Just be certain that the discount you offer is less than what you have determined is your cost per sale.
Another option is to offer an additional product or service, or a higher quality version of the product/service. Consider when a customer contacts its cable service provider, even if it is just to resolve a billing issue. What does that rep do (in addition to resolving the issue, of course)? They present additional options for upgrades in service, with attractive pricing. That rep is already on the phone with the customer, and the overhead costs is already there. But, if that overhead cost is offset by an up-sell, then the cost per sale is drastically reduced.
Sell complimentary products at the same time. If you are selling eco-friendly cleaning products, for example, and you have a customer ready to purchase your floor cleaner, how about your window cleaner, your multi-surface cleaner, or even your new eco-friendly dish soap? The more you can sell in one interaction, the better profit margin you have.
2. Speed Up Turnaround Time
The faster an order can be filled and shipped, the less overhead cost per product there is.
Take a look at how you can speed up this process. What can you automate? How is your inventory organized? How many steps are involved in the ordering, fulfilling, and shipping out of an order? And how can you reduce the human labor involved in all of this? Maybe your computer systems need to be updated, so that they involve fewer humans in the process. Or you can organize your inventory better so that pulling product is more efficient. Perhaps, you can also lower shipping costs by exploring vendor options.
One of the biggest savings is in human labor. And when you can reduce them, your cost per sale will really reduce as well.
3. Focus on Retention
It’s always a great feeling to get a new customer. But this is a costly endeavor in terms of marketing, interactions, etc. Some marketing experts estimate, in fact, that it can cost at least 6X more to acquire a new customer than it does to retain existing ones and continue to nurture their loyalty. And those costs make any cost per sale to a new customer decrease your profit margin.
On the other hand, current customers are:
- Are 50% more likely to try a new product (cross-selling) and they spend on average 31% more than a new customer.
- Current customers are more likely to listen to your offers. Some estimates state that you have a 60-70% chance to sell something new or existing to a current customer, and only about 5-20% chance to a new one.
- Customers can actually do some of your marketing by becoming brand advocates to their friends and family. Getting a recommendation from someone they trust drives customers to your company.
4. Perform Cost Analysis on Products/Services and on Customers
Do you know how much, on average, it is costing you to sell a specific product? Do you know the comparative popularity of your products or services? You can do a profit margin analysis on each of your products and, often, on each of your long-term customers?
When you find really low profit margins on some of these, it’s time to re-think your continued efforts. Companies discontinue products all the time. Why? Because they have performed the analyses, and the profit margins are just too low. They are better spending more time and effort promoting those products that are providing much higher margins.
This is a double-whammy. First, you cut the production costs for a product you discontinue, and second, you can work to increase the profit margins of those products that are performing well.
The same goes for customers. If you are using an email marketing service, for example, you are paying for lots of things – including cost by numbers of emails sent out. Purging your email list regularly eliminates the costs of marketing to people who have never been and probably never will become customers.
5. Take the Time to Evaluate Waste
Are you ordering more materials than you need in given time periods? Are you keeping too much product in inventory? If yes, that means, you are producing too much. Producing less is a cost savings all the way around. Are you spending money to buy leads that really do not pan out? Are you putting money into marketing efforts that are not bringing results?
All of these things are wasting money and digging into you profit margin. When you eliminate the waste, the profit margin, and the ultimate real profits, go up.
So these are just five great tips to make you business more “lean and mean” and help you increase your profit margins. Some you may already have in place. But if you are not carefully looking at each of them and making sales plans that include them, then you are missing out on potential profit that is not going to cost you more to acquire. And isn’t that an attractive thought?
Photo by Afta Putta Gunawan