Unraveling the Mystery of Profit Margin Analysis

Why do entrepreneurs own and operate businesses? To make money. But the amount a company makes is not measured by revenue alone.

A business also has expenses. Looking solely at the profit amount doesn’t reveal the whole truth. True earnings are what remain after the owner pays for expenses. The foundation for proper income assessment is an examination of the percentage of revenue you retain as profit. This is your profit margin.

Calculating Profit Margin

Profit margin is the ratio of profit to sales, expressed as a percentage. Wise small-business owners maintain judicious scrutiny over both gross profit margin and operating profit margin.

Gross margin is your profit after paying all the direct costs for completing sales, which is typically called cost of goods sold. Numerous factors may be considered in identifying cost of goods sold. A retail operation has costs for the merchandise it sells. A service organization has costs for labor and perhaps some materials or parts. Regardless of the nature of your business, it has some cost of goods sold.

Still, even a sole proprietor with no employees or inventory may determine a gross margin. This is accomplished by subtracting reasonable compensation as an “employee” of the business from the amount of revenue, then dividing the result by the revenue. For example, a bookkeeper may want to earn $35 per hour for work performed because that’s the cost for hiring someone with the necessary skills to provide the effort. If the business receives revenue of $50 for a one-hour project, the gross margin is 30% because only $15 of gross profit remains (15/50 = 0.3 or 30%).

Of course, business owners are responsible for paying general operating expenses, too. The profit remaining after all these overhead expenses are paid is divided by revenue to calculate the operating profit margin.

Analyzing Profit Margin

These calculations should guide business owners in operational decisions. An examination of gross profit margin can lead to smart reforms in pricing and costs. The most knowledge can be gained by calculating gross margins for various types of sales.

Attaining this degree of detailed information requires a bookkeeping system that tracks revenue and direct costs for each product line or type of business. Some companies identify gross margin by territory or for each sales representative. As long as revenue is paired with its associated costs, the data present a straightforward determination of profit margin.

Low gross margins are improved by raising prices, finding lower cost inputs, or even discontinuing an entire line of business. Operating profit margins are stabilized or increased by effectively controlling expenses. Conversely, a fall in operating profit margin is an indication of unsound expense management.

Businesses with strong profit margins maximize the available cash to grow the company by hiring more staff, increasing space, or expanding marketing efforts. Alternatively, operations may use funds from higher profit margins to reduce debt or pay larger distributions to owners.

By contrast, falling profit margins impose burdens on the business. Slashing expenses and downsizing become the byproduct of lower profit margins…along with reduced compensation to ownership.

Ultimately, profit margin is foundational to business success. Close monitoring of this indicator is a key strategy for business owners to optimize resources for a prosperous future.

Not All Surprises Are Good: Know What to Expect on Your Tax Bill

It’s virtually unavoidable. When your business makes a profit, you pay income tax.

Some of your business earnings automatically belong to the government, which means you get to hold on to that money only for a limited period before handing it over to the tax collection authority. But you don’t have to be surprised by this bill. Plan ahead and use careful accounting to avoid unexpected tax bills.

Examine your business balance sheet regularly. This statement should have a liability account for accrued taxes. Consequently, the true amount of funds available for spending in your bank balance is the total minus the tax liability you must eventually pay.

Since most small businesses operate with cash-basis accounting, accrued liabilities on the balance sheet are not technically correct. Cash-basis expenses are counted only when they’re paid, not when they accrue. To keep your books in order, move the reserves for income tax into an entirely separate bank account. In your bookkeeping, you will transfer funds from one asset bank account to another.

This provides the advantage of having government cash out of the business operating account. Instead of an accrued liability for taxes appearing on the balance sheet, the funds available for business functions are simply the bank operating account on the balance sheet. Tax payments are remitted from the tax account.

The optimal amount of money to save for taxes is a subject to discuss with your tax accountant at the end of every year so you can appropriately plan the next year’s reserves.