So you have implemented your business model and your business is operating more efficiently, now it’s time to start tracking that money!
Think about it this way, your profit margin is a financial metric that measures the profitability of a business by expressing the amount of profit as a percentage of the revenue. It is used to determine the efficiency and profitability of a business by comparing the amount of money the business is bringing in (revenue) with the amount of money it is spending (costs).
There are different types of profit margin, but the most common is gross profit margin and net profit margin.
- Gross Profit Margin: Gross profit margin is a measure of a company’s profitability from its production or sales activities. It is calculated by subtracting the cost of goods sold (COGS) from the revenue and dividing the result by the revenue. The formula is:
Gross Profit Margin = (Revenue – Cost of goods sold) / Revenue
So for illustration purposes, let’s say a small clothing retailer had revenue of $100,000 and their cost of goods sold (COGS) was $60,000. The gross profit margin for this business would be calculated as follows:
Gross Profit Margin = ($100,000 – $60,000) / $100,000 = 40%
In this example, the gross profit margin is 40%, meaning that for every dollar of revenue, 40 cents are left over as gross profit after accounting for the cost of goods sold. This is a useful metric for the business owner to monitor as it gives insight into the profitability of their sales activities and allows them to make informed decisions about pricing and product sourcing.
- Net Profit Margin: Net profit margin is a measure of a company’s overall profitability, taking into account all expenses including COGS, operating expenses, taxes, and interest. It is calculated by subtracting all expenses from the revenue and dividing the result by the revenue. The formula is:
Net Profit Margin = (Net Income) / Revenue
Continuing with the above small clothing retailer, they had revenue of $100,000 and their cost of goods sold (COGS) was $60,000. To calculate the net profit margin, we need to consider all of their expenses, including operating expenses, taxes, and interest. Let’s say their operating expenses were $20,000 and their taxes and interest amounted to $10,000. The net profit margin for this business would be calculated as follows:
Net Income = Revenue – COGS – Operating Expenses – Taxes and Interest Net Income = $100,000 – $60,000 – $20,000 – $10,000 = $10,000
Net Profit Margin = (Net Income) / Revenue = $10,000 / $100,000 = 10%
In this example, the net profit margin is 10%, meaning that for every dollar of revenue, 10 cents are left over as net profit after accounting for all expenses. This is a useful metric for the business owner to monitor as it gives insight into the overall profitability of their business and allows them to make informed decisions about costs and expenses.
A higher profit margin indicates that a business is more profitable and efficient at generating revenue. A business with a higher profit margin has more room to invest in growth, expansion, and future projects. A business with a lower profit margin may struggle to invest in growth and expansion, and may have to cut costs or raise prices to maintain profitability.
It’s important to note that profit margin can vary depending on the industry and the specific business, and there is no “average” profit margin that applies to all businesses.
