Profit Margin definition
We all know that when running a business, profit is a good indicator of how well youíre doing. But while you might bring in millions of pounds each year, if your costs are equal to or even higher than your income, your profit margin will be poor once your outgoings are accounted for.
Your profit margin is the difference between how much it costs you to make, produce or retail a product or service and how much you receive back from the customer. The more profit you make on each item, the larger your profit margin will be.
Gross Profit Margin Definition
Gross profit margin refers to the difference between the cost of goods or services sold and the revenue theyíve generated. It does not take into account any further business expense that could reduce the amount, but is still a good indicator of how healthy a revenue your products or services are generating. Gross profit margin will always be larger than net profit margin, but the amount to which the two vary greatly depends on your business costs. Factors that contribute to gross profit margin are often variable, such as the price of direct or raw materials needed to provide your service or product.
Net Profit Margin Definitions
The net profit margin is the size of the profit margin that remains after you have deducted all costs and business expenses. This includes things such as paying staff wages, accounting for variable prices of materials and any taxes that apply to your business or service. Itís normal for your net profit margin to be significantly lower than your gross profit margin, particularly if you need to employ lots of staff to provide your goods or service or deal with expensive materials.
However, if your net profit margins seem to be small without good reason, itís worth re-evaluating your company to see if anything can be streamlined or any costs reduced. It may be that reducing staff numbers, finding a cheaper supplier or switching to more cost-effective methods are what you need to see a smaller gap between your gross and net profit margins.
If your net profit margin is zero or below, your business isnít currently profitable and youíre spending more money than youíre bringing in. This may occur during expansion, a poor trading period or at the beginning of your business journey where youíre faced with a lot of one-off costs but havenít yet built up a customer base.
A brief period of a negative profit margin does not have to signal the end of a business, but if your costs are consistently higher than the revenue youíre generating, itís wise to see where you can save money quickly. If your business continues to not be profitable, you may find your company descends into insolvency, so address poor net profit margins as promptly as you can.
Calculating Profit Margin
Profit margins are generally expressed as a percentage, but itís not uncommon to see them in decimal form. Calculating your profit margin is fairly straightforward, as it is essentially about subtracting the money that youíve paid out from the money thatís come in, to get a clear picture of what the difference is.
For example, if your business makes £10,000 in sales, this is your Ďgross profití as youíve not yet taken away any of your costs from it. Itís easy to get excited about a period of good sales, but itís important to remember that not all of the money you make in gross profit is yours to keep.
Now for the costs. Letís say your products cost £5,000 to make and you spend another £3,000 on operating costs (like wages, taxes and overheads). In this case, your net income is £2,000.
Then, youíd need to divide your net income by how much you made in sales, which in this case would leave you with a net profit margin of 0.2. If youíd prefer to see it as a percentage, simply multiply it by 100. In this scenario, your business would have a healthy profit margin of 20 percent.
Laid out as a formula, this looks like:
Total sales Ė (cost of products sold + operating costs) = net income.
Net income / sales = net profit margin.
Net profit margin X 100 = net profit margin as a percentage.
This formula can be applied to any business to calculate its net profit margin, no matter how large or small its revenue is.
Is bigger always better?
The bigger your profit margins, the more money youíll be taking home, but it may be that itís sometimes necessary to sacrifice a percentage of your profits in order to improve the company. For example, if you have an exceptionally impressive profit margin, but employ a very small number of employees who are struggling to cope with the workload, itís sensible to employ more staff. This will reduce your net profit margin but will improve the longevity of your business as youíll have better staff retention, performance and satisfaction. If you fail to invest in the health of your employees and business, you may find it crashes and burns in just a few short years.
You may also need to sacrifice some of your profits for the sake of quality. It may be that you source your goods or materials through a low-priced supplier, but if customers arenít satisfied, you may need to find a better source or risk losing work. Again, it will reduce your net profit margins, but it will ensure your competition doesnít snatch up your clients and that you keep your business alive. In short, profit should not be prioritised over the quality and longevity of your business. After all, if your business goes under, you wonít be making any money at all.
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