As you grow your business, there are some key financial metrics that you should track and review frequently. You don’t need to become a professional accountant, but you will need to understand what these metrics mean and how they relate to your business.
One of the most important numbers in your business is your profit margin.
Simply put, the profit margin determines the rate at which your company makes money. There are many ways to track the profit margins of your company, and these numbers all help you to adjust your operations to maintain financial stability.
Keep reading to learn more about calculating profit margins and maximizing them for your business.
How to Calculate Your Profit Margin
The simplest way to track your profit margin is with this formula:
(Net Sales – the Cost of Goods Sold) / (Net Sales) = Gross Profit Margin
The cost of goods sold (COGS) refers to the cost of labor and materials to create the products that are sold. For example, a business would include the materials used in assembly and the hourly rate of employees. This calculation might also include the cost of machinery and other expenses related to the business.
At a high level, companies can use the profit margin to assess how successful their business currently is.
Companies also look at profit margins on a micro level. This helps them to identify which items have a higher gross margin than others. For example, beverages have an incredibly high profit margin and are essential for restaurants to stay open.
Let’s use this formula on a bottle of wine compared to the cost of an appetizer:
($25 price for a wine bottle – $10 cost of the bottle) / $25 restaurant price = 60% gross margin
($12 appetizer price – $8 of ingredients) / $12 appetizer price = 33% gross margin
Profit margins can be calculated as percentages or as monetary units; however, percentages provide a more realistic view of which item is more profitable. In the example above, the wine with a 60% gross margin brought in $15 for the restaurant in profits. However, it’s more profitable than a wine bottle that only has a 50% gross margin that also brings in $15.
Once you can calculate profit margins, you can start to make decisions and changes that will make your business more profitable.
How to Improve Your Profit Margin
As you can see, your profit margin isn’t a single number. You can look at the profit margin of individual items, of specific departments, and even within different store locations. You can also make multiple adjustments to areas that affect the cost of goods sold or increase the sale price to increase profit margin.
Here are a few tips to increase your profit margins:
- Decrease your cost of materials. You can do this by changing suppliers or working out discounts for buying in bulk. This step allows you to maintain the price while increasing your profit margins through lower COGS.
- Decrease your cost of assembly. Manufacturing costs contribute to your COGS. For example, if you invest in a machine that creates items 5 times faster than an employee, you can increase your production, reducing the hourly cost of creating the item each time.
- Increase your prices. Raising prices to accommodate materials costs, or inflation, is normal and expected—however, some of your customers might push back against the increase if there isn’t an explanation or any added value to them.
- Decrease the amount or volume you offer. This practice (called shrinkflation) is common in grocery items. Products will maintain the same price, but the items’ quantity will shrink by a few ounces to increase product margins.
- Reduce lost inventory. When items are lost, stolen, or broken, they don’t contribute to your total profits, but they do contribute to your COGS. The fewer items you lose or can’t sell, the higher your profit margin will be.
You can also take a targeted approach to your profit margin. For example, if you sell 25 different items, you can remove the 5 items that have the lowest profit margins and replace them with high-margin items.
However, you will need to make sure these aren’t your best sellers, or you may lose customers when these low-profit, high-sales items are discontinued.
Tools to Improve Your Profit Margin
The best way to track your profit margin is to maintain good financial organization. Consider working with an accountant to track your profit margins and develop a report to review which items are keeping your business in the black. If you don’t already use QuickBooks for your business, now may be a good time to start. (There are also many classes you can take online or in-person to learn this software.)
There are also specialty tools you can look into to help monitor your margin. Mavenlink has specialized profit margin software for projects, and Jobber Academy has a free calculation tool that you can use to get a basic idea of your costs.
By keeping an eye on your profit margin, you can make strategic decisions to grow your business that will help increase your income without negatively impacting your customers. The goal: create a sense of value that will help you move products and keep people coming back for more.