What is the profit margin?
The profit margin of a business is considered to be one of the most important indicators of the viability of a business. Simply put, it is the amount by which revenue from sales exceeds costs in a business.
What are the different types of profit margin?
There are two main types of profit margin that are widely used across most businesses, gross profit and net profit, and many factors combine to affect what your profit margin will be.
Gross profit margin – Also referred to as net income, the gross profit is what a business makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services.
Net profit margin – This is the actual profit made by a business after working expenses (not included in the calculation of the gross profit) have been paid.
There is however, a third type of profit margin which is called operating profit margin and is how much profit a company makes on a GB pound of sales after paying variable production costs (cost that depend on volume of output), such as wages and raw materials, but before paying interest or tax. Operating profit margin includes costs of goods sold (COGS), costs associated with selling and administration, and overheads. The COGS formula is the same across most industries, but what is included in each of the elements can vary.
How do you calculate the profit margin for a business?
Calculating profit margin can be achieved via simple mathematics formulas:
The gross profit margin can be calculated by (Revenue – COGS) / Revenue x100. The gross profit margin reflects how successful a company's executive management team is at generating revenue, considering the costs involved to produce their products and services. The higher the number, the more efficient the management team is at generating profit for every £GB pound of cost.
The gross profit margin is calculated by taking total revenue minus the COGS and dividing the difference by total revenue. The gross margin result is then multiplied by 100 to show the figure as a percentage.
The net profit margin can be calculated by Net Income / Sales = Net Profit Margin. The net profit margin provides a better representation of a business’ financial health than sales revenue, as a business can increase its sales whilst decreasing its profit margin.
The operating profit margin is a good indicator of how well a company is being managed and how efficient it is at generating profits from sales. It can be calculated by Operating Earnings / Revenue = Operating profit margin. Operating earnings are a company’s earnings before interest and tax (EBIT). EBIT is simply calculated as Revenue minus Cost of goods sold (COGS).
What factors can influence the profit margin?
Two key factors that can dictate your profit margin are Quantitative factors and Qualitative factors.
Quantitative factors – The numbers are the easiest factors to understand and arguably the easiest to address effectively. At the top level, the key factors include:
- your net profits.
- your sales revenue.
- your costs.
You just need to look at your income against your costs for a general view of how your business is performing.
Sales prices and merchandise costs are also key. If you can control, or even reduce your costs while increasing your sales prices, then you can significantly and quickly increase your profits.
A quantitative factor that needs to be carefully managed is the stock that you hold. Devalued stock can significantly hurt profit margins, so reducing your stock via increased sales helps improve profits.
A variable that you have little or no control over is taxation. Increases to corporation tax, VAT, import and export duties, will affect profits.
Qualitative factors – There is a multitude of qualitative factors that can affect your profit margin, such as:
- your market share (is it increasing or decreasing?).
- you’re advertising and marketing (is it effective and driving high volumes of leads and sales?)
- are your products susceptible to seasonal changes?
- are consumer preferences changing?
- do you offer, or have you changed your, consumer reward programs?
- have your competitors strengthened or weakened?
In the main, these factors are out of your control, but that doesn’t mean you can ignore them. Constant monitoring of your target markets and your competition is important to assist you in your ongoing business strategy so you can remain competitive.
For example, if your competitors have strengthened, can you identify what they have done to achieve that? Can you replicate it for your own business? Can you improve in it?
How you can increase your profit margin
As mentioned in the previous point, the quickest way of increasing your profit margin is to reduce your costs while increasing your sales prices at the same time.
Obviously, increasing prices could result in reduced sales volume as your customers look elsewhere for alternatives. Reducing your costs is always welcome by senior management teams and finance teams, but it is important to retain the same quality of goods, where possible, otherwise your customer complaints may increase, trust will be lost, and your customers may be compelled to look elsewhere for alternatives.
The retail market sector is a good example to look at when it comes to thinking about your own product pricing as it constantly changing its own pricing due to how competitive it is.
Some key examples of increasing your profit margins can include:
•Increase your inventory visibility to avoid markdowns – Greater control over your stock and what items are fast movers and which are slow movers will help you to make better decisions around purchasing, sales and marketing. All of which should help you reduce the compulsion to reduce prices.
•Focus on the unique positioning of your brand – If you can differentiate in any way from your competitors, then you might be able to elevate your brand and improve its perception of value in the eyes of your customers.
•Get lean and reduce your costs – Many companies look to increase prices to increase their profits, but it can be far easier to improve profits by streamlining your business operations. By focusing on areas of waste in your business you can significantly reduce your costs. Automate your processes as much as possible to reduce time, manpower, and operating expenses. It’s important to manage this process carefully, so you don’t compromise quality of your goods and services.
•Look to increase your average order value (AOV) – You’ve invested your time and money in winning customers and/or compelling customers to your business or online store, now you should look at how you can maximise their spend with you. Upselling and cross-selling is a tried and tested way of increasing AOV, and as your customers are already qualified and already know and purchase your products and services, then they should be significantly more receptive to your advertising.
•Look at bulk buying to reduce your order costs – Analyse your inventory data to determine which products are the most popular. Will your budget stretch to increasing your orders for your most popular products? If so, can you negotiate bulk-buy deals with your suppliers to reduce the unit cost?
•Increase your prices – The most obvious way of potentially increasing profits, but not necessarily the most popular. Increasing prices during a recession will likely reduce the volume of your custom rather than increase your profits. However, in some cases even a very small price increase can make a big difference and your customers won’t be too perturbed by it either.
•Improve relationships with your vendors – Not all small businesses have vendors, but those that do can reduce costs and optimise sales by improving vendor relationships and communication. Studying your supply chain can help you identify areas where there are greater costs than are necessary.
•Look to your staff for greater output – This doesn’t mean you must tell your staff to work harder or do more hours. Assess what your staff are currently able to do and ask if there is anything that is slowing them down? This could be a certain internal process that takes time to complete, or it could be a need for enhanced training to improve efficiency.
•Reduce your business costs – Cost of suppliers and inventory are obvious candidates for optimisation, but what about the general costs of running your business? Heating, lighting, business insurance, rent of premises, fuel for company vehicles. All of these are candidates for discussion and their costs can usually be improved upon.
You don’t always need to make significant changes to greatly improve your bottom line. Sometimes a culmination of minor tweaks can yield gains and more importantly, wider margins.
