When running a business, it is essential to understand the key terms. Even if you are directly over the accountancy side of the enterprise, you are certainly concerned with whether or not the business is turning a profit!
With this in mind, we’ll take a look at ‘profit margin’, what it means, and how to calculate it.
Table of Contents
- Why Profit Margins Are So Important to Understand
- Gross Profit vs. Net Profit vs. Operating Profit Margin
- How to Calculate Gross Profit Margin
- How to Calculate Operating Profit Margin
- How to Calculate Net Profit Margin
- Real Life Profit Margin Examples
- What is a Reasonable Profit Margin For My Business?
- 5 Best Ways to Improve Net Profit Margin
- Bottom Line
Why Profit Margins Are So Important to Understand
In both corporate and local businesses, the ‘profit margin’ definition is one of the most widely utilized metrics. The reason it is so important to come to terms with this definition is that there are actually 3 distinct types of profit margin – gross profit, net profit, and operating profit. It’s easy to mistake one kind of profit margin for another. If you are buying or selling a business, you have to be able to make these distinctions. More detail about the different kinds of profits is given below.
Profit margins are calculated as a percentage of total revenue. So if you earned $300,000 with a $60,000 net profit, your operating net margin is 20% (which is quite good). The number has to be given as a percentage because this makes it easier to compare businesses.
However, it can also be misleading. A 100% net profit margin on a business with annual revenue of $10,000 isn’t much. But a 10% net profit margin on a business with annual revenue of $1,000,000 is pretty impressive.
The single reason that profit margins are so important to understand is that it is the most important metric when analyzing the viability of a business. Regardless of nearly all other factors, a strong net profit margin is an indicator of a strong company. Because at the end of the day, businesses are built on profit. Much of the rest is irrelevant if you have a high-profit margin and high annual revenue.
Gross Profit vs. Net Profit vs. Operating Profit Margin
To delve into profit margins a little more deeply, let’s compare the 3 major profit margins – gross, operating, and net. Gross profit is the least informative, then operating profit, and finally net profit.
- Gross Profit Margin – This is the total profit calculated by subtracting the ‘Cost of Goods Sold’ (‘COGS’) from the profit. COGS is a term used to represent the total cost of manufacturing the product or service and not associated expenses. So gross profit margin serves to indicate your profit for your goods sold against the cost to produce those goods. For instance, raw materials and labor might be included, while taxes, debt financing, overheads, and one-off purchases will not be.
- Operating Profit Margin – This is a little more complicated as compared to the gross profit margin. The operating profit margin takes more metrics into account when calculating profit. Other items included in the calculation will be amortizing debt and asset depreciation, along with COGS. Debt, tax, and other non-operational expenses are still excluded.
- Net Profit Margin – The most important metric of them all. The net profit margin will be the lowest and the most accurate, as it takes everything into account for the purposes of calculating profit. In fact, when people ask about profit margins, this is the metric that is most relevant and most often used. It is little use having an excellent gross and operating profit margin if the net is significantly lower due to certain expenses. This should be investigated first, and only then should the other 2 metrics be considered. The net profit margin will include all expenses (including debt, taxes, secondary operational expenses, and one-off expenses) and is the most relevant and accurate.
How to Calculate Gross Profit Margin
Sometimes, gross profit is referred to as ‘gross income’. A high gross margin and a small net margin is often indicative that something needs to be changed and that there are some operational inefficiencies at hand. To calculate gross profit margin, you subtract your total revenue from your Cost of Goods Sold. This leaves you with a gross profit.
Next, you need to express this as a percentage. Do this by dividing by the total sales and multiplying by 100. For example, let’s say your total revenue is $100,000 and the COGS is $60,000. This leaves a gross profit of $40,000 ($100,000 – $60,000). Next, divide your gross profit ($40,000) by the total revenue ($100,000) and multiply by 100. You are left with a 40% gross profit. In sum, the two necessary formulas for gross profit margin are:
How to Calculate Operating Profit Margin
Operating profit is sometimes called ‘operating income’. It is calculated by adding the total COGS along with operating expenses (necessary expenses to keep the business running). It does not include debt, taxes, one-time payments, and secondary operating expenses.
To run with the example given above, let’s say you have a COGS of $60,000, total annual revenue of $100,000, and operating expenses of $25,000. Your operating income is $15,000 (COGS + Operating Income – Revenue). Divide your operating income ($15,000) by total annual revenue ($100,000) and multiply this figure by 100. The end result will be 15%. In sum, the two necessary formulas for Operating Profit Margin are:
How to Calculate Net Profit Margin
Net profit is sometimes called ‘Net Income’. Net Income/Net Profit Margin is the most accurate in terms of the viability of a particular business, as it includes the most elements in its calculations. In addition to all of the items mentioned in calculating the operating profit margin above, it will also include payments on debts, taxes, one-off expenses, and any income from investments or secondary operations.
To calculate the Net Profit Margin, we must subtract debt, taxes, one-off expenses, and secondary operations from the Operating Profit above. The same business (as above) may have an annual debt of $2,000, taxes of $5,000, a one-off expense of $3,000, and secondary operational expenses of $2,000. This adds to a total of $12,000.
Subtract this figure from Operational Expenses ($15,000) to arrive at a net profit margin of $3,000. Express this as a percentage of total annual revenue ($100,000) and you get a result of 3% Net Profit Margin. In sum, the two necessary formula for calculating Net Profit Margins are:
Real Life Profit Margin Examples
For the year ended in 2019, the annual revenue of McDonald’s was $21 Billion, quite a large figure. But this figure reduces significantly when expenses are taken into account. The gross profit of McDonald’s is $11.11 Billion in the same year. The operating income was $9.07 billion. And finally, the net income is $6.025 Billion. For a large international food chain, this is quite an impressive percentage, roughly 30%.
Compare this to another international chain, such as Starbucks (‘SBUX’). It’s revenue in 2019 was $26.5 Billion. Its gross profit was $17.98 Billion and it’s operating profit was $4.08 Billion. Finally, its net profit was $3.59 Billion. Represented as a percentage, the net profit of Starbucks in 2019 was roughly 15%, half that of McDonald’s but with a bigger annual revenue and a smaller total profit margin. There is a huge reduction in the gross profit of Starbucks and the operating profit.
In the year 2019, the total net profit of McDonald’s was twice that of Starbucks. All other things remaining equal, McDonald’s should be worth twice as much. Of course, in reality, there are many other factors to consider, such as the total assets, debt, liabilities, and how much is earned per share. Both corporations spent about $10 Billion on COGS in 2019.
What is a Reasonable Profit Margin For My Business?
Obviously, different people will expect different profit margins. But it certainly helps to know the averages. Don’t expect to open a restaurant with 50% profit margins. It’s just not that kind of industry. And don’t automatically expect to obtain the average, either.
Just know all of the necessary expenses and what you are up against, and aim to slowly but surely increase your profit margins. The table below should give you a realistic estimate of the profit margins you can expect in terms of what industry you are entering into. Take note that even within these industries, there are subcategories that may be significantly higher or lower than the averages given below.
|Industry||Gross Profit Margin||Net Profit Margin|
|Auto Repair and Maintenance||21%||12%|
|Hotels and hospitality||76%||8%|
But the above should serve as a useful baseline if you are getting started or want to reach a certain milestone. The profitability margins above were taken from a review of over 7,200 companies across 90 industries in the USA.
Different studies may generate different averages. The total gross average profit margin for a retail outlet is 53.33% – This was the figure arrived at after a study of over 13,000 retail outlets (note this is 12% lower than the US figure in the study above, possibly because the USA is more affluent than other regions). This figure has very little variance across regions – the UK, the USA, Africa, Australia, and New Zealand.
But there are massive profit margin differences per industry. For instance, beverage, jewelry, and cosmetics had profit margins of 65%, 62%, and 58% respectively. Alcohol, sporting goods, and electronics had lower figures of 35%, 41%, and 43% respectively.
5 Best Ways to Improve Net Profit Margin
There are many ways to improve the profit margins of your business. But it will largely depend on the industry you are in. Just keep in mind that there is always a way to improve your profit margins. You just need to get a little creative and give the matter some deep consideration. The following are 5 of the more traditional (and best) ways you can improve your profit margins.
#1 – Cut Overheads
Looking to grow profits is great. But first, you should look into streamlining operations so that operating expenses are reduced. This will help when your business grows, as the operating expenses will grow in proportion. This is a big area, and there are many ways to cut expenses. But you must do it in such a manner that the essential service is in no way compromised. In many instances, you can increase efficiency and customer satisfaction while reducing overhead, provided you do it intelligently.
Cut staffing and overtime down only to what is absolutely necessary. Automate specific tasks as much as possible. The biggest companies, like Amazon and Starbucks, excel at automating routine functions. It can vastly reduce operating expenses. Go through the employee routine tasks and see where you can automate. Ditch any fancy packaging that is unnecessary and has a low-cost system that takes care of a number of operations, such as payroll, inventory, point of sale, wages, and marketing.
#2 – Increase Average Order Value (‘AOV’)
If you get a customer to visit your retail outlet or to visit your website, then much of the work has been done. It’s far easier to get an existing customer to spend more than to try and acquire a new customer altogether. In the context of the restaurant industry, this is always done by both small businesses and chains – ‘would you like anything else with that” or ‘would you like a drink to get started’ or ‘would you like dessert?’. These innocuous statements can get people to spend more than they would if they were not so encouraged.
In an online context, the average order value is increased by grouping related items together. Amazon does this with ‘customers who bought this also bought’ and then shows a list of related items to get customers to increase their average order value. You can also increase the average order value with discounts, coupons, sales, and other marketing phenomena. Just don’t make it too obvious! Customers do not like being pushed.
#3 – Foster An Emotional Connection
One reason why the beauty and cosmetics industry has such a high-profit margin is that it fosters an emotional connection with customers. Customers do not purchase based on logic or rationality. They purchase based on emotions. Beauty items are also directly involved with making customers feel better about themselves.
Whatever way you can, try to create a relationship between you and the customer. It could be as simple as asking them how their day is going and if there is anything else you can do for them.
If you sell items online, a handwritten letter in an alternative writing style and signed by the owner can go a really long way towards creating a positive ambiance and ultimately a repeat customer who buys your products, and increases your profit margins.
#4 – Experiment With Pricing
This does not simply mean raising prices, though it can be as simple as that. If you are selling a number of items, as nearly all businesses will be, then you are likely to have a number that are selling very well. Experiment with these and ask why they are selling particularly well. You could focus on these items exclusively or push them more aggressively.
You might also see that you can charge more for certain items or that you can charge less for others. There are many psychological studies behind pricing. You might implement a tiered pricing structure where you entice people to select a higher tier (though in reality, the customer would not have gone for that option if it was priced differently). Business is largely about psychology, and you need to get creative with how you market and what you charge for goods and services.
#5 – Get Your Employees To Work For You
It might seem that your employees always work for you, right? But this is often not the case, and they are often only there to do a job and collect a paycheck. You can motivate your employees to produce more output without resorting to aggression or viewing them as mere wage slaves to maximize output.
Talk to them. Find out their opinions. Remove hurdles and operational inefficiencies. Create quarterly metrics and experiment with friendly competitions to reach goals and target objectives. You have to manage your employees properly and make them feel respected and part of the team.
The end result will be that the employees take some initiative and take pride in their work. Ultimately, your job will be a lot easy with happy and productive employees. And the end result will be a fatter profit margin for the business.
Profit margins are an essential part of running a business. It critical that you understand the difference between:
- Gross profit margin
- Operating profit margin
- Net Profit margin