A key measure of the success of a small business is profitability. And an understanding of profit margin is necessary in order to assess whether you’re on a trajectory to success, or not.
Profit margin is where you begin when you’re shaping a complete business strategy, as it reveals input cost trends and the effectiveness of your pricing strategy. Net profit – the most commonly understood measure of your company’s profitability – is determined by subtracting all business expenses from business sales. Therefore, the net profit margin is profit as a percentage of sales. To calculate, divide net profit by sales, and then multiply by 100 to attain the percentage.
It’s all relative
Depending on your industry, your net profit margin might be 2% or 20%. Finding the average net profit margin for your type of business may require some online research. An accountant familiar with the industry may be able to help as well.
The key is to scrutinize your company’s profit margin in the most recent period compared to earlier periods. A rising margin is clearly a victory signal. Conversely, a declining margin calls for constructive solutions to stop the deterioration.
Impact of gross profit
However, you may want to get a handle on your gross profit margin before you take any significant steps. Gross profit is business revenue minus direct costs of the sales. A retail store, for example, calculates gross profit by subtracting the cost of items sold from the revenue obtained when selling them. Dividing gross profit by revenue results in the gross profit margin percentage.
A business providing services can also determine a type of gross profit by identifying the direct costs that vary with revenue.
If you sell various services, evaluate the gross profit margin for each category. If some of the services you provide incur a lower gross margin than others, your resources are likely better spent by focusing on the most profitable areas. This would free up resources for less costly services.
Components of net profit
Once you understand gross profit margin, it’s time to complete your analysis by looking at operating expenses. Net profit margin considers all expenses, including general overhead costs that are not directly connected to revenue generation. If gross profit margin is steady, but net profit margin is declining, overhead operating expenses are the culprits.
Calculate the percentage of expenditure categories relative to revenue. Start with the largest expenses; for many small businesses, these targets are rent and labor costs.
After identifying the types of expenses with significant changes when compared to revenue, you can decide whether action is required. Nonrecurring events can cause temporary spikes in operating expenses, which lower net profit margin. But a permanent increase in an overhead cost represents an ongoing cut in profitability. Adjusting an operating expense is generally the easiest method for restoring net profit margin.
Source: Gold Gerstein Group