Profit Margins: A Complete Guide for Small Business Owners
Small businesses need to be profitable in order to be successful. After all, if you aren’t bringing in money, you can’t pay the bills. But saying that you want your small business to be profitable and actually putting in the work to make sure it is are two different things.
You can do all the marketing in the world and bring in a ton of clients, but if you don’t consider pricing, profit margins, and cost efficiency for your small business, then you could still end up losing money.
In this post, we’ll review the different types of profit margins, why they’re important, and how to calculate them.
What are operating, gross, and net profit margins?
To really set your business up for long-term success, you need to know each of your individual costs—from bills to actual job tasks and supplies. That way, you can figure out how much money you need to make from every job to ensure each one is profitable.
That percentage (the difference between your expenses and what you charge a client) is your profit margin.
But, there’s more to it than that.
You should calculate your operating, gross, and net profit margins separately to really understand how your expenses and revenue change over time.
READ MORE: What is revenue? We do a deep dive with an accountant to break it down for you.
What is operating profit margin?
Your operating profit margin is how much money you make after you cover all the costs for a job (like employee wages or job materials) but before you add on any taxes or interest.
For example, if your company did a job and charged the client $150, and your costs were $100 before taxes and interest, your operating profit margin would be $50 (or 33%).
Your operating profit margin is typically shown in a dollar amount as opposed to a percentage.
So, how is this useful?
Operating profit margin is a good way to get a quick look at how well your business is performing.
It tells you how much money you have to put towards costs outside of the operation of your business, such as taxes.
You can use it to see if your job expenses increase or decrease over time and make adjustments as necessary.
If you notice your operating profit margin shrinking, it means your job costs are likely going up, so you can start to look into why, how, and find a solution.
Keeping track of it over time also helps you to see how much your operating costs vs gross profit change positively or negatively as you grow.
How do you calculate operating profit margin?
To calculate your operating profit margin, divide your operating income (earnings before interest and taxes are deducted) by your net revenue (the amount you make after direct costs are subtracted).
Operating profit =
What is gross profit margin?
Your gross profit margin is the amount of money you have left from jobs (or sales) after you subtract the cost of goods.
Cost of goods only includes expenses directly associated with the completion of a job (like labor and material costs). It does not include indirect expenses like general overhead such as office rent, marketing costs, vehicle insurance, etc.
So, unlike operating profit margin (where you included all costs except for taxes and interest), to calculate your gross profit margin, you only use your cost of goods.
Generally, your gross profit margin is a dollar amount instead of a percentage.
So, why is this important?
Your gross profit margin is important because it helps you to keep track of your labor and material expenses.
You can use it to see how these expenses grow or decrease over time.
This gives you an indication of when you need to reconsider a contract or make a supply change.
For example, if your gross profit margin shrinks over time, it may be because your supply costs have slowly increased. This could mean that you need to renegotiate material prices or find a new supplier.
How do you calculate gross profit margin?
To calculate your gross profit margin, take your net sales and subtract your cost of goods. Then, divide that number by your net sales.
Gross Profit Margin =
Net Sales – Cost of Goods
What is net profit margin?
Your net profit margin is how much money you have left from sales after all your expenses have been subtracted.
This includes your operating costs, taxes, interest, and cost of goods. The amount you subtract should include everything from labor and material costs to gas, bills, loans, etc.
Your net profit margin is what tells you how much you are making after all your expenses have been paid.
Generally, when people refer to a profit margin, this is the one they are referring to. This number is almost always referred to as a percentage instead of a dollar amount.
So, why is this important?
Net profit margins can tell you a lot of different things about your business.
If your net profit margin fluctuates significantly over time, it can help you to identify which areas need your attention.
For example, perhaps you need to restructure your pricing model or maybe you’re seeing a lot of growth in a new location and you could stand to focus on some marketing efforts there.
Your net profit margin should increase over time, which indicates growth.
If it doesn’t, you should evaluate all your costs to determine which area is causing you problems.
This can help you to keep find and fix issues before they do too much damage.
How do you calculate net profit margin?
To calculate your net profit margin, take your total revenue and subtract your total costs. Divide this number by your revenue. To convert it to a percentage, multiply the resulting number by 100.
Net Profit Margin =
Revenue – Total Costs
READ MORE: Use these five tips (including profit strategies) to make your business successful
Why are profit margins important?
Without profit margins, it’s going to be hard to tell how well your business is really doing.
It’s not enough to simply book jobs and hope for the best.
Ideally, you should be keeping track of all your different profit margins on a regular basis such as monthly or even bi-weekly.
By doing so, you can stay ahead of any issues, like cost increases or market changes that can affect your business. You can also identify “profit monster jobs” that help you make money, rather than lose money.
They’re also used by investors, banks, and other lenders to determine the financial health and potential of your business.
Not only do they give a clear indication of how well your business is doing, but they also show that you are a capable and savvy manager.
This can help when you are looking for extra funds to fuel growth.