There are few thoughts that occupy the minds of small business owners more than finding new ways to maximize profit margins. The unfortunate reality, though, is that many small business owners have no clue where their profit margins should sit.
Profit margins vary widely by industry, which can complicate matters further, with highly profitable industries like alcohol and food service netting comparatively high margins (with some quarters exceeding even 34%). But not all business owners should use their local watering hole as the benchmark for their own profit margins.
The truth is, coming up with a target profit margin is a highly personalized process that must account for your business’s various characteristics and operating costs. To help you find our what is a good profit margin or the average profit margin for your industry and location, read on as we walk you through the process from end-to-end.
What Your Profit Margin Says About Your Business
There’s a lot of information that is “baked into” your existing net profit margin. The lowest of the low end of profit margins hover around the two percent range, such as in the grocery store, automobile dealership, lawn care, and beverage manufacturing industries.
On the other end of the spectrum are industries such as dental care, car rental services, and tax and accounting services which consistently run net margins over 20 percent. Even if your business finds itself within one of these industries, it still isn’t a good idea to assume that you can secure such astronomical margins.
Instead, you need to consider other factors that affect profit margins. Here are some of the main variables that factor into the equation:
- Labor costs
- Use of assets
- Equipment maintenance
- Inventory management
- Cost control systems
- Physical location
- Tax and regulatory environment
In other words, no two profit margins will ever resemble each other perfectly. Just because another company in your field nets a certain percentage does not imply that your business will be able to generate the same profits under the same conditions.
Variations in the number of employees, skill levels, tax rates, and scale all play into the profit margin that your business will be able to pull in quarter after quarter.
Signaling to Investors
When investors see that a startup is more concerned with increasing profitability over growth, alarm bells go off in their heads. During the early stages of small business ownership, you shouldn’t be preoccupied with what your industry’s average net profit margin is.
Instead, it’s usually best to focus on taking Amazon’s approach to growth by reinvesting profits into the company to spur long-term growth. While a gross profit margin signals to investors that a company can turn revenue into profit, it says nothing about your business’s ability to remain profitable over time or the amortization and depreciation of your assets.
The Difference Between a ‘Good’ and ‘Average’ Profit Margin
What is considered a good profit margin and an average profit margin for a small business depends on your industry, long-term growth goals, and the state of the economy overall. Mostly, overhead costs are what make the difference between a high and average profit-generating business.
Independent consultants have virtually no overhead costs compared to, say, a restaurant or nightclub owner who has to account for rent, payroll, inventory, and many other recurring expenses.
Here are the top three variables that influence a company’s profit margin:
If you run a brick-and-mortar clothing retailer, you can’t compare your net profit margin to your customer’s online consulting firm. Apples to oranges comparisons such as these are why many small business owners aim way too high when calculating a good profit margin.
Second, expansion goals need to be accounted for when arriving at a target average profit margin. If you’re satisfied with your business’s revenue as is, then there’s no need to ramp up expenses or reinvest profits. For those who want a larger slice of the pie, aiming above 20% profit margins can make the difference between withstanding downward market fluctuations.
Last, it’s important to account for scale when finding your target profit margin. Startups with few or no employees have fewer expenses and are therefore more likely to generate higher margins. By contrast, mega-corporations with rent, payroll, and employee benefits like Ford, Target, and Wal-Mart only bring in between 3.9 and 5.2 percent margins.
Net Margin vs. Gross Margin
A net profit margin is the ratio of net income (i.e., income after expenses, depreciation, etc.) relative to revenues. To arrive at this figure, simply divide your net profits by your revenue. Essentially, net margins determine the share of your sale price that you keep after considering all the sunk costs that go into it.
Net margins, also known as net profit ratios, are always lower than gross profit ratios and operating profit ratios. As such, they are the best representation of your company’s financial health and overall efficiency, because it considers all the overhead costs that went into the sale for a good or service.
Issues with the Net Profit Ratio
As a short-term measurement, net profit ratios are useful, but they say nothing of your company’s chances of staying profitable over time. Heavy capital investment, research and development expenses, and marketing expenses can drive down one’s net profit ratios even though they’re solid indicators of long-term growth.
Worse yet, business owners may buff up their net profit percentage by simply delaying certain discretionary expenses. Therefore, net profit margins are subject to some degree of artificial adjustment. That’s why it’s important to keep in mind that net profit ratios only tell a portion of your company’s financial story.
How to Calculate Your Profit Margin
Similar to calculating your company’s operating cash flow (OCF), calculating profit margins involves a bit of simple division. However, this doesn’t make the process isn’t tedious, because it certainly is. You need to ensure that you keep track of every expense, so you have an accurate figure of your sunk costs (right down to maintenance and transaction fees).
Although there are accounting tools available to help you quickly find your margins, you can quickly calculate it yourself using a pen and paper.
To find your gross profit margin, start by taking the retail price of a product or service and subtract the cost of labor and materials that go into making it. Once you have that figure, divide it by the retail price to find the gross profit margin of that item. For instance, a $50 product that costs $40 to produce has a gross profit margin of 20 percent.
To find your net profit margin, which is used to determine the company’s overall profit margin, you need to subtract all expenses from revenues. Then, divide that sum by total revenues to find your net profit margin. In other words, a business with $2 million in sales and $1 million in expenses should would a net margin of 50 percent.
Tips for Improving Your Profit Margin
The question of “what is a good net profit percentage” often shrouds the judgment of small business owners. Instead, a good profit margin can usually be generated by simply reducing overhead expenses wherever possible. The lower your overhead, the higher your margins.
Watch Your Sales
You need to determine what is a good profit margin for a product or service and cut all those that fail to reach this predetermined threshold (i.e., cut your “loser” products). For instance, if you sell coffee at 50 percent margins but pastries at 5 percent, then your pastry inventory may need to be cut back.
Pad Your Inventory
One of the most effective ways to boost your profit margin is to plan your inventory wisely. Take the time to research your market so that you meet product demand without overstocking or suffering a shortage. It’s generally a good idea to slightly overestimate supply of whichever products generate the highest product margin (i.e., your “winner” products).
Profit Margins and Your Bottom Line
Profit margins are taken seriously by business owners, investors, and analysts because they hold an enormous amount of utility: in one convenient number, your net profit margin speaks volumes about your company’s financial health. However, unless it’s taken in context—with your industry, goals, and scale in mind—then your profit margin can send the wrong message.
The key is to assume that average small business profit margins are too variable to trust. A small car dealership, for instance, will not and should not generate the same margins as an upstart consulting firm. Instead of using your margins as a comparison metric, consider your net profit margins to indicate your business’s financial sustainability in the short-term.