Profit margins – a guide for small business owners

Want to understand how profitable your business is? Read our expert guide to how to calculate and improve profit margins as a new business.

New business owners need to know their profit margins to understand the financial health of their start-up. Generate more money coming into your company than going out in costs, and you’re on to a winner. Calculating profit margins and learning how to improve profits can give you more money to invest in your business and grow further.

 

Whether you’re operating a business-to-consumer company selling products or you’re in the business-to-business space and providing services, being aware of all your costs and how they affect profitability is crucial. Having passion and a love for what you do are necessary, but your business won’t be successful without making a profit and having good profit margins.
 

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What is profit margin?

The goal of every business should be to make a profit. That’s the amount of money you’ve made once all costs have been taken into account. Your profit is measured as a figure in pounds.

A profit margin is a measure of your company’s profitability and is calculated as a percentage. It shows how much money your business retains for every pound it makes in sales.

Increasing your sales does not necessarily mean you’ll increase your profit margin. You could be successful at generating more business, but by doing so, your costs could increase due to the need for more marketing or new employees. These additional costs will reduce your profit margin.

That’s why knowing your profit margin is essential for understanding your costs.
 

The different types of profit margin

There are three types of profit margin – and you’ll need to understand all three to achieve success as a business owner.

Gross profit margin

Your gross profit margin is the percentage of revenue that your business retains after you’ve deducted direct expenses.

Direct expenses are costs associated directly with making and selling your product or services, known as the cost of goods sold (COGS). It includes the costs of raw materials, equipment, manufacturing supplies, wages for people required for directly making a product, and transporting goods.

Understanding your gross profit margin will help you monitor your direct costs and ensure they aren’t excessive.

Operating profit margin

Operating profit margin is the percentage of income remaining after you’ve deducted the operational costs for the day-to-day running of your business. These are variable costs and include rent, insurance, accountancy fees, marketing, entertainment, office supplies and travel costs. Your operating profit margin is your earnings before interest and taxes (EBIT), so you shouldn’t include tax and debt interest payments when calculating your operating costs.

Knowing your operating profit will help you keep an eye on your business’s running costs, and you can easily see if you need to make reductions to improve your margin.

Net profit margin

Net profit margin is the percentage of revenue retained after deducting all direct costs, operating expenses, interest payments and taxes.

Net profit margin is one of the most important indicators of the financial health of a business. You must know it so that you understand the full performance of your company.
 

How to calculate your profit margins

As an example, we’re using a business that makes £40,000 in sales revenue. Its direct costs are £16,000, and operating expenses total £10,000.

Working out your gross profit margin

  • sales revenue – direct costs = gross profit
  • gross profit / revenue x 100 = gross profit margin

First, you need to work out your gross profit. You do this by subtracting your direct costs from your sales revenue. For the example business:

£40,000 – £16,000 = £24,000.

To work out your gross profit margin, you divide your gross profit by your sales revenue and multiply by 100. For the example business:

£24,000 / £40,000 = 0.6 x 100 = 60. The gross profit margin is 60%.

Working out your operating profit margin

  • gross profit – operating costs = operating profit
  • operating profit / sales revenue x 100 = operating profit margin

First, you need to work out your operating profit by subtracting your operating costs from the gross profit. For the example business:

£24,000 – £10,000 = £14,000

The operating margin is calculated by dividing the operating profit by sales revenue and multiplying it by 100. For the example business:

£14,000 / £40,000 = 0.35 x 100 = 35. The operating profit margin is 35%.

For this calculation, you need to take depreciation into account. Depreciation is the term used to describe the reduction in the value of fixed business assets such as IT equipment. This means that your profit will be reduced because you’ll need to replace the equipment at some point which increases your costs.

You also don’t include tax and loan interest payments, as operational profit is based on things a business can control.

Working out your net profit margin

  • revenue – (direct costs + operating costs + taxes and interest) = net profit
  • net profit / sales revenue x 100 = net profit margin

To work out your net profit margin, you first need to calculate your net profit by subtracting your total costs from your sales revenue. It includes all direct and operating costs explained above, plus tax and interest payments.

For the example business, let’s assume it has paid £3,000 in taxes and interest:

£40,000 – (£16,000 + £10,000 + £3,000) = £11,000.

To work out your net profit margin, you divide the net profit by the total sales revenue and multiply by 100. For the example business:

11,000 / 40,000 = 0.275 x 100 = 27.5. The net profit margin is 27.5%.
 

What is a good profit margin?

Many new business owners ponder what a good profit margin is, but there are no fixed rules. Putting it simply, the higher your margins, the better.

The Office of National Statistics tracks the profitability of UK companies, and figures in December 2019 showed the average profit margin was 9.3% for private non-financial businesses, 9.4% for manufacturing companies and 14.9% for service firms.

Be careful with comparing your profit margins with businesses in other industries, as profit margin depends on the sector in which you operate. For example, a business consultant or accountant with limited overheads is likely to have higher profit margins than a consumer product business with high costs for raw materials and manufacturing.

Luxury jewellery companies can have profit margins in excess of 40% because they sell their products at high prices. In contrast, food businesses generally have lower margins because the difference in their costs and the prices they charge customers is less. Studies have shown that average profit margins for full-service restaurants are between 3% and 6%.

But just because one business has lower margins than another doesn’t necessarily mean it’s better. Profit margins measure the percentage of revenue that is profit rather than the amount of money you’re making or what you could make in the future.

Ultimately, whether you have a good or bad profit margin comes down to what you want to achieve with your business.
 

How to improve profit margins

If you have a low-profit margin, you should work on improving it. Methods include:

1. Increase your pricing or sales

Consider increasing your prices or find ways to upsell existing customers to buy more products or services. Review your marketing and find new and cost-effective channels for promotion. You could also form collaborations and partnerships with other businesses.

Read our guide on how to win new customers.

2. Reduce your direct costs

Look for ways to cut your COGS by finding cheaper suppliers or negotiating lower rates for raw materials, transportation and equipment. Costs can also be reduced by outsourcing business activities to external experts and using contractors instead of full-time employees.

Read our guide to outsourcing.

3. Reduce your operating costs

Cut your operating expenses by taking actions such as reviewing your client and employee entertainment costs and stopping any unnecessary activities or using cheaper suppliers and venues. You could also run more online meetings to reduce travel costs and switch to more affordable energy and utility suppliers.

 
 

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Disclaimer: While we make reasonable efforts to keep the information on this page up to date, we do not guarantee or warrant (implied or otherwise) that it is current, accurate or complete. The information is intended for general information purposes only and does not take into account your personal situation, nor does it constitute legal, financial, tax or other professional advice. You should always consider whether the information is applicable to your particular circumstances and, where appropriate, seek professional or specialist advice or support.

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