What Is a Good Profit Margin, and How Can You Achieve It?
Business owners examine their own profit margins to determine whether they’re making enough money or not. Lenders analyze profit margins to work out if a company can make repayments on loans and finance facilities they’re applying for. Investors base much of their decisions on whether they’ll provide financial backing to a company based on its current or future predicted profit margins.
There are so many factors that influence profit margins. They include the industry sector you operate in, your geographical location, your internal organization, and the experience of your management team.
But what is a good profit margin? In this article, we’ll share:
The different types of profit margin
What constitutes a good profit margin
How to improve your company's profitability
What Types of Profit Margins Are There?
There are many different ways to determine what a company’s profit margin is. Each way of measuring profitability holds clues for business owners, lenders, and investors on how well a company is run.
The three main ways of analyzing profit margins are gross profit margin, operating profit margin, and net profit margin. But there are also a few other metrics we’ll cover below as well.
Gross Profit Margin
Your gross margin is the amount of money you have left after you’ve subtracted the cost of goods sold (COGS) from total revenues.
COGS includes what accountants call “direct costs.” Direct costs are expenses that you can attribute to the production of goods and services.
If you’re a retailer, this would include the cost of buying finished products from your supplier. If you’re a manufacturer, this would include the cost of the raw materials you buy to create the end product as well as any other supplies you use in the production process.
Direct costs also cover the wages you pay to your employees who are directly involved in the production process as well as any costs of maintaining machinery or equipment needed to create a product.
To put this into context, let’s consider three different types of business and what expenses would be included in a COGS calculation:
In a grocery store, COGS is the purchase cost of the inventory you buy and then sell. Some accountants may also include the wages of checkout and shelf-stacking staff as, without their efforts, a sale could not take place.
In a food service business like a restaurant, your direct costs would include food and drinks, kitchen staff wages, and kitchen equipment usage.
In manufacturing, COGS includes the wages of your workers on the assembly line, utility costs for running the production machinery, and the operational costs for maintaining and using the manufacturing equipment.
The formula for working out your gross profit margin percentage is: (Gross Profit Margin = (Total Sales - Cost of Goods Sold)/Total Sales) x 100
If your gross profit margin is low, your business may struggle to make money when your operating expenses are factored in. Examine your gross margin closely to determine whether you’re spending too much money on the ready products or raw materials you’re buying or the staff who serve the customers at the point of sale.
Operating Profit Margin
Your operating margin is the remaining cash you have left after you’ve subtracted the cost of goods sold and your operating expenses from your total sales.
Operating expenses are your “indirect costs.” Accountants classify indirect costs as expenses that can’t be traced back to a specific product or service. That means they are general costs that support the operation of the business and that it couldn’t function without.
Indirect costs include expenses like rent, bank charges, office supplies, accounting charges, legal fees, and more. It also includes the cost of employing people not directly involved in the creation of goods and services.
You pay indirect costs regardless of your level of revenue — although how much you pay may be affected by your level of revenue.
For the three types of businesses we featured above, you’d factor the following overhead expenses into an operating income calculation:
In a grocery store, you would include business expenses like store maintenance costs, marketing costs for promotions, utilities for areas in the store not used for selling (like office space and storage), and staff in administration and managerial roles.
In a food service business like a restaurant, you’d factor in overhead costs like rent for the dining area, utilities for non-kitchen spaces, front-of-house and administrative staff wages, and costs for maintaining equipment and decor in the dining area.
In manufacturing, you’d include sales, managerial, and admin wages, factory rent for areas where no production takes place, and maintenance of non-production equipment.
To work out your operating profit margin, start by calculating your operating profit:
Operating Profit = Total Sales - Cost of Goods Sold - Operating Expenses
Then, the operating profit margin formula is:
Operating Profit Margin = (Operating Profit / Revenue) x 100
Operating profit margin is an important financial metric in any business. A standard accounting rule of thumb is that a low operating profit margin can point to inefficiencies in the way the business is managed. For example, you may be spending too much on maintenance, administration, or marketing, which leads to lower profit margins even if your sales are healthy.
Net Profit Margin
Your net margin, also known as net profit margin, is the percentage of net sales left after you have subtracted COGS, operating expenses, interest, depreciation, and taxes from your net sales. This is different from net income, which is how much you have in cash after paying out all the expenses.
The meanings of these terms are:
Interest: This is the cost of borrowing that lenders charge to you on financial instruments like working capital loans, business lines of credit, commercial mortgages, and so on.
Taxes: These are charges you pay to government entities like corporate income taxes and property taxes.
Depreciation: Depreciation is the value your assets lose (like commercial kitchen equipment or a delivery vehicle) over time. Depreciation reduces your profitability but saves you money on corporate income tax.
Net sales: Net sales are different from total revenue as they factor in the financial impact of deductions like returns, discounts, and allowances from your gross figures.
To work out your net profit margin, start by calculating your net profit with this formula: Net Profit = Net Sales - Cost of Goods Sold - Operating Expenses - Interest - Depreciation - Taxes
Then, the net profit margin formula is: Net Profit Margin = (Net Profit / Net Sales) x 100
A low net profit margin can indicate poor financial health in a business because it suggests that there is not much left after all expenses are accounted for. Startups and small business owners in general should aim for higher profit margins as cash flow can be tight in the early days of running a company.
Other Ways of Measuring Profit Margins
There are other, more niche ways of describing profit margin including:
EBITDA: Short for “Earnings Before Interest, Taxes, Depreciation, and Amortization,” investors and analysts use EBITDA to compare the operating performance of companies in the same industry without taking into account financing and accounting decisions.
EBIT: Short for “Earnings Before Interest and Taxes,” this allows investors and analysts to compare companies across industries by focusing on their operating profit. This is a useful way of measuring how profitable a business’s current operational setup is before factoring in the impact of financial structuring like their levels of equity (how much their owners have invested) and debt (how much they owe external lenders).
NOPAT: Short for “Net Operating Profit After Tax,” this is how much a business earns minus the taxes they have to pay. It’s a way for investors focused on the day-to-day performance of a business to analyze how well a company is doing without considering how it manages loans or what its tax strategy is.
What Is a Good Profit Margin?
According to data from NYU’s Stern School of Business, the average net margin across U.S. businesses is 8.89%. When financial services businesses are removed from the calculation, that benchmark reduces to 7.77%.
Profit margins vary greatly from year to year and from sector to sector. This is for a wide range of reasons, including operational efficiency (how much equipment and how many people it takes to deliver a product or service to an end user) and market trends (some industries may be in recession while others are booming).
As a result, what constitutes a good profit margin varies between different industries.
In the banking sector, 28% is the typical profit margin while restaurants usually reach around 9%. Hence, a restaurant achieving a 28% return would be operating at a very high-profit margin for its industry. In contrast, a bank hitting only a 9% return is encountering a low-profit margin in its field.
Why does the definition of a good profit margin vary so much? Let’s look at banks vs. restaurants to help explain. First, managing money is less labor-intensive than serving a three-course meal. Second, banking is far more scalable, which introduces further cost savings through economies of scale. These kinds of differences (and more) across industries result in profit margins being apples-to-oranges comparisons.
To determine what a good profit margin is for your business, look at your industry average, your competitors, and your own historical performance. For example, here are a few industry averages based on January 2023 data, which further illustrates how different margins can be in different industries:
Food processing: 7.10%
Auto parts: 2.16%
Furniture and home furnishings: 2.03%
How to Improve Your Company’s Overall Profitability
There are many different approaches you can take to improve your company’s profitability. Six of the most popular are:
Look at your pricing strategy: If your pricing strategy has been based on charging customers less than your competitors, look at it again. If your rivals are getting away with charging more and they have no shortage of customers, there’s no reason you can’t charge more either.
Haggle with suppliers: One of the best ways to achieve a good gross profit margin is to ask your suppliers to charge less for their products. They may require you to buy more from them on each order, but if you’re confident you can sell all of the inventory you purchase, you’ll make more money on each sale.
Look for new customers: Find brand-new customers through new marketing channels and partnerships with other companies. You may be doing very well at targeting one or two types of customers, but there may be other demographics out there who’d be as interested in your products but they’ve never heard of you.
Sell a wider range of products: Look for complementary products and services you can sell to your existing clients. This is a great way to increase the lifetime value of a customer. Plus, your new products and services might bring more clients to your store or website.
Adapt your business model: If your customers buy from you regularly, don’t wait for them to come into your store or order online. Set up a subscription service so that you can supply them every week or month automatically. This is great for guaranteeing future revenue.
Open in new markets: Increase sales volumes by winning new business from clients outside your local area. Alternatively, you could add your products to third-party platforms like Amazon and eBay to reach the widest possible audiences.
Lock in Your Business’s Future by Operating With a Healthy Profit Margin
So, what is a good profit margin? A good profit margin is where your business is making enough money to generate the working capital you need to build your company to the fullest potential.
Businesses with strong profit margins are more attractive to investors and lenders. Both want to see a proven ability in the companies they work with to generate profit and manage costs effectively.
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