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.