No margin for error: Calculating your profit margins
Krystal Stubbendeck comes from a family of seven, but it wasn’t until her friends started having children that she noticed the challenges of staying in style as bodies changed from day to day. She launched Borrow For Your Bump, an e-commerce platform that lets women borrow maternity and nursing clothing during pregnancy and shortly after they give birth.
At first she focused on clothing that provided the most value to customers, like casual clothing they could wear daily. However, those pieces came back so worn they couldn’t be rented again. After careful analysis, she realized the most profitable items were formal wear and focused more on clothing that turned over more quickly. This change allowed her to boost her profit margins, and ultimately keep her business running.
Not All Sales Equal
Most small businesses strive to increase revenues, but they often fail to take into account their profit margins. “Not all sales are equal; you want to increase those sales that maximize profit without a significant or equal increase in costs,” says Michael Gallagher, an official with the Small Business Administration.
Profit margins come in two forms:
Gross profit margin: Typically, this equation is used to determine the profit margin of a single product or service, allowing you to figure out the profitability of each of your offerings and determine if you’re mispricing a product or service. The calculation is made by taking all the costs associated with producing a good or service, subtracting that from the revenues that are generated from the good or service, and then dividing by the revenue. If you sell a product for $50, and it costs $40 to make, your gross profit margin is 20%.
Net profit margin: This equation, which determines an entire organization’s profit margin, requires you to subtract total expenses from total revenues over a given period, and then divide that figure by total revenue.
Determining profit margins requires exactitude. You need to keep track of everything including expenses like payroll, utilities, and shipping and every source of revenue, even smaller items such as transaction fees.
Ways to Boost Margins
Profit margins vary by industry. According to Investopedia, farmers make about a 3% profit, while the alcohol industry has a net profit of 19.13%. Because of the variance, it’s important to benchmark your profit margins against companies in your industry to determine if you’re doing well or need to make adjustments. There are a variety of ways to boost your profit margins, including trimming expenses, eliminating services and products that aren’t pulling their weight, or adding more products and services that don’t increase your overhead.
Profit margins can indicate whether a company is in solid enough shape to weather a rough patch. “Many analysts and investors take profit margin so seriously because it can contain an enormous amount of information about a company into one efficient, easy-to-understand number,” says Brian Beers, a writer for Investopedia.