Money talks, especially if you’re running your own business.
It’s not everything, of course. But at the end of the day, your investors, business partners, and lenders want to see metrics for success.
It’s time to take control of your business finances. And that makes understanding your profit margin–and what makes a good profit margin.
What is a good profit margin? We’re glad you asked. Here’s a quick guide to understanding some of the most important numbers for your business.
Understanding Your Margin: Net vs. Gross
There are two types of profit margins: net profit margin and gross profit margins.
Net profit margin refers to how much profit is generated as a percentage of revenue, while gross profit margin measures the percentage of sales revenue remaining after subtracting the cost of producing and selling goods.
Net profit margin is what you talk about when you talk about your bottom line. It’s the metric of choice for investors and business partners to measure the overall profitability of your firm.
Gross profit margin measures the financial efficiency of a process or product, allowing you to determine whether a product is profitable. It can also tell you how good you are at creating a product when compared to your competitors.
Calculating the Profit Margin Formula
Since net profit and gross profit are two different things, you have to calculate them in two separate formulas.
There are a few options for calculating your net profit margin, depending on what you want to include. The generally accepted method is to divide your after-tax profit by sales. However, some analysts prefer to include minority interest so that they know how much money was made before paying minority owners.
So, you have two options:
- Net income after taxes / revenue = net profit margin
- (Net income + minority interest + tax-adjusted interest) / revenue = net profit margin
Calculating your gross profit margin is blessedly simple, if tedious.
Start by calculating your gross profit (net sales revenue – cost of goods sold = gross profit). Net sales is your gross revenue minus discounts, returns, and allowances. Then, divide gross revenue by gross profit.
So, in plain English, follow these three formulas in order:
- Gross revenue – (discounts + returns + allowances) = net sales
- Net sales revenue – cost of goods sold = gross profit
- Gross profit / total revenue = gross profit margin
This will give you your company’s profit after covering production costs and before paying administrative costs.
What Is a Good Profit Margin?
With all that in mind, what’s a good profit margin, anyway?
A good profit margin depends on your industry, the economy, and a host of other factors. Some companies, like restaurants, have much higher overhead costs than others, which means a smaller profit margin can still be considered good.
Your profit margin depends on:
- Your industry
- Your geographic area
- The age of your business
- The size of your business
- Your expansion goals
Younger businesses tend to have lower overhead costs, which means their profit margins are higher even if their revenue is low relative to their overall industry. Smaller businesses also have fewer expenses than larger businesses, which increases their profit margin even though their income is lower.
According to S&P 500 reports last year, profit margins above 11% outperformed the market, while a profit margin under 15-20% indicated vulnerability to market changes.
Keep in mind, however, that it’s difficult to compare all small businesses against one average because businesses operate so differently. A financial advisor can help you figure out your profit margin and determine your metrics for success based on your unique situation.
Mastering Your Business’s Finances
Asking, “What is a good profit margin?” is a lot like asking, “How much money do I need to earn this year?”
It all depends on your business.
That said, we know that uncertainty is daunting for small business owners. That’s why we’re here to help you make sense of your finances. Check out our blog for more useful tips, like this post on how to make financial projections for your startup.