How to calculate profit margin - and why it’s important
Your profit margin tells a story about your business’ health. Here’s how to work it out – and avoid common mistakes.
Whether you’re Amazon, Alibaba, or running an organic skincare business from your home office, you need to be clear about your profit margin at all times because it’s a fundamental indicator of business performance.
What is profit margin?
Profit margin is the percentage of every dollar you keep from each sale.
As MYOB CFO Caroline Rawlinson explains, “Profit margin is calculated by dividing your business’ net income by your revenue, then multiplying by 100.”
So, in other words, if your revenue was $100,000 and the cost of your product was $70,000, then your gross profit margin would be 30 percent.
Why profit margin matters
Getting into the habit of regularly checking in on your profit margin enables you to:
- Keep your expenses and returns visible at all times so you can spot issues such as pricing and cash flow before they become problems.
- Decide if you can afford to invest in growth activities such as innovation, research and development or new hires.
- Be clear about whether your business is making a profit, breaking even, or in danger of closing down.
“Important investment and operational decisions should be made based on profit margins, so ensuring it is accurately calculated is vital,” Rawlinson advises.
How do you monitor your profit margin?
Producing a monthly profit and loss statement (a “P&L”) is a key part of monitoring profit margins.
Most modern accounting software packages can do this for you and are relatively inexpensive and easy to use. Or you can visit the U.S. Small Business Administration to download a template and create your own.
“Take time each day to keep your records up to date so your profit and loss statement is accurate. Think about it as your daily banking – an essential administration task that must be done,” says Richard Harling, a senior retail consultant at Retail Life.
What is a good profit margin?
In short, it depends on your industry.
Vend reports that the average North American retailers’ gross profit margin (their profit margin before expenses) was 53.5 percent in 2019. However, net profit margins for U.S. retailers generally sit below 10 percent. Some U.S. industries have much higher margins; alcoholic beverages can command net profit margins of more than 20 percent, while healthcare technology businesses deliver around 13 percent net profit margins.
To find out how your profit margin is tracking against your competition, it’s helpful to find out your industry benchmark. A good place to start is with the U.S. Census Bureau.
Want to improve your profit margin?
Read Afterpay Access stories about how to boost your business’ profitability and the three money mistakes small businesses often make.
And lastly, don’t make these four mistakes when it comes to calculating your profit margin...
Not having a full picture of where your money is going “The most common mistake – especially for anyone new to business financials – is not including items such as depreciation and interest in expenses. This makes profit artificially high,” Rawlinson points out.
Not paying yourself a wage “Some owners don’t cost their own labor, but you have to include this when calculating your overall business expenses,” Rawlinson says.
Incorrectly pricing goods and services “Knowing your profit margins will help you clarify what margins to place on your goods and services so you make a profit,” Harling states.
Lack of processes “When a business is starting out there is often a misconception that setting up proper accounting or business systems isn’t worth the time, cost or effort, but doing so is a great way to set it up for long-term success,” Rawlinson adds.
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