Understanding and Improving Profit Margins

As a business owner, understanding profit margins is essential for maintaining a healthy business. Knowing your profit margins helps you make informed decisions about pricing, expenses, and growth opportunities. This article will guide you through calculating your profit margins and explain why they are critical for your business's success.

How to Calculate Your Profit Margin

Profit is essentially the money you make from your work after paying all your expenses. It's what’s left over when you subtract the costs of running your business — like materials, labour, and overhead costs — from the total revenue you earn. Basically, it’s your earnings that contribute to your business's growth and success. 

Profit margins reflect how much of your revenue remains after accounting for expenses. There are two main types of profit margins: gross profit margin and net profit margin.

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Calculating Gross Profit Margin

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The gross profit margin is a percentage that shows how much money a business makes after subtracting the cost of goods sold (COGS) from its revenue. It indicates how efficiently a business is producing its goods or services. In basic terms, a higher gross profit margin means the business keeps more money from each sale to cover other expenses and make a profit.

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Imagine a plumber who completes a job for $1,000. The cost of materials and supplies for that job is $400. The gross profit margin is calculated by subtracting the costs ($400) from the revenue ($1,000), leaving a gross profit of $600. To find the gross profit margin percentage, divide the gross profit by the revenue: ($600 ÷ $1,000) × 100 = 60%. This means the plumber keeps 60% of the revenue to cover other expenses and profit.

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To calculate gross profit margin:

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1. Determine revenue: Start with the total revenue generated from your work (e.g., completed jobs, services provided).
2. Calculate Cost of Goods Sold (COGS): Identify all direct costs associated with the work, such as materials, labour, and other job-specific expenses.
3. Apply the formula:
   
   
   1. Gross Profit = Revenue − COGS
   2. Gross Profit Margin = (Gross Profit ÷ Revenue) × 100

For example, if your revenue is $10,000 and COGS is $6,000, your gross profit is $4,000. Thus, the gross profit margin would be:

Gross Profit Margin = (4,000 ÷ 10,000) × 100 = 40% 

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Calculating Net Profit Margin

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The net profit margin is the percentage of revenue that remains as profit after all expenses have been deducted. This includes not only the cost of goods sold but also operating costs, taxes, and interest on debt repayments.

For example, if a tradie earns $1,000 from a job but has $900 in total expenses (including materials, labour, overhead costs, and taxes), their net profit is $100. The net profit margin would be calculated as ($100 ÷ $1,000) × 100 = 10%. This means the tradie keeps 10% of the revenue as profit after all expenses are paid.

To calculate net profit margin:

1. Calculate total expenses: This includes all business costs — overheads, operational expenses, marketing, administrative costs, and taxes — alongside COGS.
2. Apply the Formula:
   1. Net Profit = Revenue − Total Expenses 
   2. Net Profit Margin = (Net Profit ÷ Revenue) × 100

Why Knowing Your Profit Margin is Critical for Business Growth

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Understanding your profit margins is vital for several reasons:

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1. Informed pricing decisions: Knowing your profit margin helps you determine if your pricing is adequate to cover costs while achieving desired profit levels. If margins are low, you may need to adjust your pricing strategy or reduce costs.
2. Expense management: By analysing your profit margins, you can identify which expenses significantly impact profitability. This awareness enables you to make strategic cuts or changes to improve your bottom line.
3. Strategic growth decisions: Profit margins indicate the financial health of your business. If your margins are healthy, it may be a good time to invest in growth opportunities, such as expanding your services or investing in new equipment. Conversely, if margins are tight, you might need to reassess your business strategy.
4. Competitive advantage: Understanding your margins helps you stay competitive in the market. You can ensure your services remain profitable while meeting customer demands and remaining competitive in pricing.

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What is a Good Profit Margin?

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The answer to this varies from industry to industry. In some industries, a gross margin as low as 5% is to be expected, whereas other industries can be above 40%. To determine whether your profit margin is where it should be, it’s a good idea to check in with your accountant for clarification. 

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If you’re noticing a lot of money coming into your business, but you don’t have much to show for it once your expenses have been paid, you could be dealing with a profit margin that’s much too low. 

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Improving Profit Margins

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To increase your net profit margin, there are some key levers you can control: 

• Reducing costs: things like negotiating with suppliers, improving processes and tax planning can help reduce your expenses.
• Increasing revenue: Evaluate pricing strategies to ensure you’re not undervaluing your services. Consider offering value-added services or upselling to existing customers to boost revenue. 

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Regularly reviewing financial metrics will also help identify areas for improvement and track progress toward your profit margin goals.

For business owners, knowing how to calculate and understand profit margins is crucial for making informed business decisions. Regularly assessing your gross and net profit margins can help you manage pricing and expenses, but also paves the way for sustainable growth. By keeping a close eye on these metrics, you can enhance your financial health and ensure the long-term success of your business.

For help with calculating your profit margin or anything else accounting-related, please get in touch with us at Bonerath & Co.

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