I’m fascinated with how easily we can trick ourselves. We play mind games to do things we don’t feel like doing, but know we should be doing anyway.
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But we can also fall victim to mind games without realizing it—like conflating the idea of being busy with being productive. Some people can get nothing important done in eight hours, while others can make great strides in three. And both can feel satisfied with how much they’ve worked.
If we aren’t careful, this can also happen with our business finances.
You might think your business is doing okay because revenue is flowing in every day. But if your overhead is high, credit card balances are creeping up, and profitability isn’t measured, you could easily find yourself mistaking motion for action and revenue for profits.
The most profitable small business owners don’t trick themselves—they just know a ton about their profit margins.
In this article, I’m going to show you the profit margin formula that will help you know if your business is actually making money.
But before we calculate your profit margin, first let’s tackle some key terms.
What is profit margin, exactly?
A profit margin is a percentage that represents how much revenue a business earns after all expenses are accounted for.
The profit margin formula looks something like this:
Profit Margin = (Total Sales – Total Expenses)/Total Sales
Let’s look at a quick example.
Say you plan to teach your kid brother about business by setting up a lemonade stand. You spend:
- $10.00 on a huge jug of filtered water
- $2.00 on lemons
- $2.00 on sugar
- $3.00 on cups,
- $20 on labor (You agree to pay your brother $20 to make and sell 100 glasses of lemonade, that you ended up selling for $1.00 each.)
In this example, here’s what your profit margin looks like:
Total sales = 100 glasses x $1.00
- Total sales = $100
Total costs = water + lemons + sugar + cups + labor
- Total costs = $10.00 + $2.00 + $2.00 + $3.00+ $20.00
- Total costs = $37
Profit margin = ($100 – $37) / $100
- Profit margin = 63%
Your profit margin helps you understand how much your business keeps as profit relative to how much it has earned in revenue. Instead of looking at profit solely in terms of dollars, expressing it as a percentage allows you to compare your profits to similar companies in your industry.
Perhaps your friend was also teaching their sister this exercise, and they made iced tea instead of lemonade. By looking at both stands’ profit margins, the two businesses could be compared, even if they only sold 50 glasses. (Hey, even the lemonade business can be cutthroat at times.)
Looking at your profit in terms of a margin also allows you to see it from another perspective. Although making a $63 profit is not very impressive on its own, a 63% margin helps us understand how profitable a simple operation like this lemonade stand truly is.
For every $1 of revenue earned, $0.63 is kept as profit. Imagine what you could do if you had $1,000,0000 in revenue—your profit would be $630,000. Not too shabby.
Gross profit vs. Net profit
There are two distinctions when it comes to looking at a company’s profit margin—the gross profit margin and net profit margin. If your company has more than one product or service, like most do, you’ll want to understand the profitability of each of your offerings.
You can do this by studying these two types of profitability margins:
- Gross profit margin is typically used to examine the profitability of a single product or service within a business. If we go back to the lemonade stand example, let’s say you start to expand your offerings to include grapefruit juice and iced tea. You can calculate the gross profit margin of each product by running through the equations we used above.
- Gross profit percentage: 63%
- Net profit margin is a ratio that is typically used to look at the entire company’s profitability. So instead of looking at how profitable iced tea, lemonade, and grapefruit juice are by themselves, you can look at how profitable the whole company is. Should you continue this lemonade stand business or pivot out of the juice stand space?
- Net profit ratio: Total profit / Total sales
Okay, here’s the deal on profit
Profitability is important because it’s how you can measure the value your business is creating by selling products and services to customers.
When you take raw materials, create something new, and package and sell them as products, or when you provide a service to your customers, you are magically creating value. That is how we justify extracting the profits we earn.
Profit is a way to put a symbol and value to an idea that is relatively intangible.
Think about what you’re selling to people as a layered cake. The bottom layers are the value of the actual raw materials. You add value when you create something with the raw materials. Without the value you add, your cake doesn’t exist.
Consumers can also create a narrative around other ways your product or service is valuable to them. Some people will pay for convenience, while others will pride themselves on how your company’s brand values align with their personal values. These are all the intangible ways people are assigning value to what you’re creating.
It’s wild when you think about it from this perspective, but if you look at really big brands, they’re not just selling a thing, they’re selling a lifestyle, an identity, a community, a process. Or even something more emotional like nostalgia, hopes, and dreams.
When your business connects with people on this level, customers are willing to pay a premium. Disneyland is a beautiful example of this. For children, they are selling hopes and dreams and that connection stays with people into adulthood.
Connecting with your customers in this way is all about building relationships, listening to their needs, and doing your best work to serve them.
Why it’s important to measure your profitability
In case you’re wondering why you should care about your company’s profit margin, here are a handful of reasons why:
- So you can price your offerings properly. When you measure profitability, you have to account for the cost of each offering. By looking at your offerings by cost, you can price them to include your profit.
- So you can grow your business, if that’s what you want to do. Understanding how your products or services are performing can inform how you invest your profits back into your business. For example, let’s say you sell ceramic mugs, bowls, and vases and you notice that mugs are not only incredibly popular with your customers, but they also have the best profit margin. With that data, you might consider investing in producing more mugs to increase the overall profitability of your business.
- So you can run a more efficient business. Profitability is a measure of efficiency. If you can do more with less money (keeping overhead low while being productive), your business is efficient. Efficiency is awesome because if you don’t want to grow your business, you can find ways to improve it without having to dramatically increase your efforts.
- So you can look good to investors or a potential buyer. If you plan to bring on investors or sell your business, potential buyers and investors will look at your profit margins.
How to measure it
1. Get good data
The best way to ensure you have useful data is to maintain timely and accurate records of your costs.
You can do this through specialized bookkeeping software. This is a huge reason why I’m such an annoying proponent of bookkeeping. It’s such a vital tool when it comes to being able to analyze and understand your business.
Instead of having to go through your bank and credit statements and manually adding things up, bookkeeping software is a database that is continuously updated so that you can quickly and accurately run the numbers needed to understand your business’s profitability.
2. Memorize the profit margin formula
You can calculate your company’s net profit margin by looking at some figures on your profit and loss statement.
Profit Margin = (Total Sales – Total Expenses)/Total Sales
For calculating the gross profit margin of a single product or service, you need to have the total cost for each offering. Finding the gross profit margin for each product or service will require honing in on your cost of goods and cost of services as well as separately tracking each revenue stream.
So what’s a good profit margin?
There isn’t a magical profit margin number for all businesses to benchmark themselves against. In other words, the measure of whether or not a profit margin is good or not is largely based on the industry.
For example, restaurants have notoriously thin margins (6% on average) relative to higher-margin, service-based businesses like consulting.
The resources below will help you understand if your profit margin is on par with other businesses in your space:
3 ways to improve your profit margin
Once you understand how the numbers on your profit and loss statement impact your profit margins, improving it is a matter of shifting those numbers.
1. Cut costs
Keeping a low overhead is a sure way to keeping your company’s profit margin healthy. If you can find ways to reduce expenses while maintaining revenue, you’ll automatically increase your profit margin.
For example, if you go through your profit and loss statement and find a way to reduce next month’s expenses by 10%, in theory, you’ve just increased next month’s profit margin by 10%. Pretty neat, right?
2. Increase revenue
A price increase may be a relatively easy way to increase revenue, but depending on how much you increase it by, it can come at the cost of losing customers who are sensitive to price.
If you can find other ways to serve your customers and clients while maintaining the same overhead (being efficient), this can result in more revenue.
Let’s go back to the lemonade stand business. Say you also serve iced tea. Offering Arnold Palmers (half lemonade and half iced tea) is a way to increase your offerings without taking on additional costs.
3. Kill your darlings
By examining your gross profit margins, you might learn that a product you offer has a profit margin so terrible that getting rid of it could drastically reduce costs—and only minimally impact revenue.
If you’ve never cut an underperforming product or service from your roster, it might be difficult at first. But the results will have a real impact on your cash flow and profit.
Even if you didn’t get into business because you love calculating profit margins, understanding it is essential for the sustained health of your company. So don’t fool yourself—just know your margins.