Why Understanding Profit Margin is Crucial for Your Business
The profit margin is the greatest indicator of a business’s growth and sustainability. It gives an idea of how well the business strategies went and what areas need improvement for the future. A good profit margin brings new investment into the business as it makes a company more appealing to investors. This article acts as a guide to instructions on how to calculate profit margin, its types and ways to improve it.
What is the Profit Margin?
Profit margin is the amount of money that a business generates relative to the cost spent on producing goods. It is the difference between revenue and the amount spent on the goods. Operating profit, net profit margin and gross profit are the common types of profit margin. Each type of profit margin is equally important as it provides information about different aspects of a business’s financial health still net profit margin is most significantly used when referring to a company’s profit margin.
Types of Profit Margin
To calculate profit margin, first, we need to discuss different types of it.
1. Gross Profit Margin:
Gross income is the profit earned on sales relative to the COGS. It is the greatest metric to measure the company’s goods production process. It usually includes variable costs and does not focus on fixed costs like rent, operating costs etc.
Formula for Gross Profit Margin
Percentage of Gross Profit = ((Total Revenue – COGS) / Total Revenue) × 100
Where COGS means the Cost Of Selling Goods
Example Calculation of Gross Profit Margin
Your business generates $25000 as revenue and the cost of producing those goods is $18000. What is the gross profit percentage?
Gross Profit= 70000 (25000 – 18000)
Gross Profit Percent = (Gross Profit ÷ $25000) x 100
Gross Profit Percent= (7000 ÷ 25000) x 100 = 28%
So, the Gross Profit Percentage is 28%.
2. Operating Profit Margin:
The operating profit margin calculates profit based on original costs(COGS) and additional operating costs. Thus this provides a better and clearer picture of business insights rather than gross profit margin.
Use our online percentage calculator to easily calculate your operating profit margin based on the information provided.
Formula for Operating Profit Margin
Operating Income = Revenue – COGS – Expenses
Operating Profit Margin = (Operating Income / Revenue) × 100
Example: Calculate Operating Profit Margin
COGS = $3500
Expenses= $1490
Revenue= $9000
Operating Income= $3500 + $1490 = $4990
Operating Profit Margin = $4990 / $9000 = 0.55 or 55%
3. Net Profit Margin
Net profit margin is the complete and detailed measure of profit, including expenses from creating goods to taxes and interest. We generally consider net profit margin when discussing a company’s profitability.
Formula for Net Profit Margin
Net Profit Percentage = (R – COGS – I -T)/R * 100
Where R= Revenue, COGS= Cost of Selling Goods, E= All Expenses, I= Interest and T= Taxes
A simple version of the above formula is:
Net Profit % = Net income/revenue * 100
Example Calculation of Net Profit Margin
What is the net profit margin percentage if a net income after all expenses is $15000 when total revenue is $50000?​
Net Profit %= 15000/50000 * 100 = 15%
Why is Profit Margin Important?
It is crucial to monitor different types of profit margins as they help shape plans and improve weak areas of a business. A good margin means sound financial health that sets a positive reputation in the market. A good profit margin also reflects the company’s successful business strategies. On the other hand, a bad profit margin indicates that a business has to improve existing workflow processes or adopt new plans that could lead to success in future.
Tips to Improve Profit Margin
If a business experiences less profit margin than expected, then it might need to follow the following tips to improve its profit
Reduce Costs
If production costs are very high, then a business needs to sell items at a higher price than the market. This causes the consumers to buy products from your competitors ultimately causing a drop in sales. Look for cheap suppliers and communicate with them to provide materials at a reasonable price without compromising quality.
Focus on High-Margin Products
Good research on high-margin products of your business can provide beneficial insights about the opportunity that can take your profit margin to a new level. Grow the audience for your high-value products by promoting them more than your other products.
Increase Prices
A very low cost of products can be a big cause of low profit. Consider raising your prices according to the production costs and communicate with consumers to justify the price increase by explaining the quality and value of your product.
Enhance Efficiency
Upgrading your production methods and improving workflow process can increase the efficiency of operations which results in generating high profit for the business. Consider your whole workflow process and try to improve areas which are causing hindrances in the progress of the company.
Conclusion
Regularly calculate the profit margins of your business for long-term success in financial terms. Evaluate gross, operating and net profit margins to identify the critical areas of your business that need improvement and make better plans accordingly.
Consider using our online calculator for accurate and quick management of your business’s finances.
