Calculating profit margin: Business basics

As a business owner, a crucial part of the role is keeping an eye on key financial metrics — understanding and calculating profit margin is a great place to start.

If the money doesn’t keep flowing, you won’t be able to keep the doors open for long.

One element of keeping track of cash flow and profits is calculating margin, so let’s explore this idea in a little more detail.

What is a profit margin?

The profit margin is a percentage that measures an organisation’s profitability.

It gives you the amount out of every dollar of a sale that turns into profits and gets kept as earnings.

For example, if your company achieved a 25 percent profit margin, that means the net income is $0.25 for every dollar of sales generated.

This margin is what you get when you subtract expenses from revenue.

What are the different types of profit margins in business?

When someone refers to a margin in business, they typically mean an organisation’s bottom line. That is, the final figure after all other expenses, including taxes, have been subtracted from revenue. This is the ‘net margin’.

However, there are also three other types of profit margins you can calculate.

The gross profit margin is what you get once you take the direct costs of your product or service (the cost of goods sold, COGS) from sales revenue.

This figure is the simplest margin to determine.

If you produce multiple goods or services, you can average out the costs of creating each or calculate a separate, gross margin for each offering.

The gross profit number doesn’t include other expenses, though, so also consider operating profit margin.

This margin acknowledges operating costs, sales expenses, admin costs, asset depreciation, research and development, marketing charges, amortisation rates, and so on.

As the name implies, the operating margin lets you know how much of each dollar you have left in profit after all the operational costs to run your business get factored in.

Pre-tax profit margins are the leftover amounts you have after taking your operating margin and deducting things like debt, interest, and any other charges or inflows (for example, income from investments) that don’t relate to your venture’s main business.

Finally, as mentioned above, the net profit margin is the final amount after
taxes get paid.

Net profit margin is the trickiest one to track since it involves so many different elements, but it’s the one that will give you the most significant insights into your company’s position.

What’s the difference between margin and mark-up?

It’s easy to get confused between the words ‘margin’ and ‘mark-up’.

They’re both financial terms that utilise the same input information (revenue and costs) in their calculations.

Margin looks at how much profit you make from a transaction. But mark-up is the amount by which the cost of a good gets increased to set its final selling price.

Mark-up is the calculation you use to make it more likely you make money on each sale.

This mark-up affects the margin you can achieve.

If you set your sale price too low or too high, you’ll end up losing sales and profits.

Mark-up percentage is shown as a percentage of costs, not revenue. It’s one of the first things you’ll consider when setting up a business and when bringing on new lines for sale.

Later, the profit margin, expressed as a percentage of revenue per dollar, will help you understand the level of actual, realised profit (or loss) you generate on each transaction.

The mark-up tells you how much money you’ll make on a specific ware relative to its direct cost, while the margin gives you information based on total revenue and expenses, with each calculated from multiple sources.

Why does it pay to understand margins in business?

Entrepreneurs must keep track of margins to know how healthy their ventures are and if there are financial issues to address.

If your profit margin is too low, not enough of each revenue dollar flows to the firm’s bottom line, indicating pricing errors.

These problems then cause cash flow concerns and can threaten the ongoing viability of your business.

Also, profit margins give you an understanding of the return on investment on expenses.

When you have a too-low margin, this indicates you’re not getting a good return on the money you outlay.

What’s a healthy profit margin?

There’s no simple answer to the question of what makes a healthy profit margin.

Different industries have different average margins, depending on the types of offerings they sell.

Plus, you shouldn’t only compare profit margins when looking at various businesses within the one sector and judging financial health.

Some firms have a low-profit margin but enjoy a high turnaround and bring in good total revenue and profits.

Examples of low-profit margin industries include restaurants, transportation, and agriculture.

Other ventures might have relatively low sales but enjoy high-profit margins and enjoy high overall profit margins that way.

Examples of high-profit margin industries include consulting and luxury automobiles and accessories.

Also, many companies have to invest a lot of money early on to develop proprietary goods such as software or pharmaceuticals.

These businesses can end up having high profit margins because the high initial research costs get balanced out by later selling millions of units, often with little or no competition.

To work out if your business has a healthy profit margin or not, learn about your industry and what the norm is.

Plus, consider how your firm operates and if this affects profit margins in ways that differ from your competitors.

Once you get clear on profit margins and how they work, you can pay close attention to how things look in your organisation.

Determine baselines and then start working on improving profit margins bit by bit.

Want to get a clearer picture of your business financials? Speak to us today on (08) 8362 4555. 

Source: MYOB July 2021

Reproduced with the permission of MYOB. This article by Kellie Byrnes was originally published at https://www.myob.com/au/blog/how-to-calculate-profit-margin/

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