What’s a ‘good’ profit margin to aim for?
There are nearly 6 million small businesses in the UK.
And, apart from a pandemic blip, that number has steadily risen over the years.
It’s easier than ever to start your own business thanks to the wealth of opportunities available across new sectors, such as dropshipping and food delivery.
In addition, the increase in smart tools available to small business owners, like intelligent employee scheduling from Findmyshift, make it easier than ever to run a business.
But what does all that mean for profits?
After all, a growth in small businesses could mean more competition.
Of course, you want your business to make as much money as possible.
But what is a realistic picture of what that looks like?
It helps to understand how profit is measured and what a healthy margin looks like.
Look out for next week’s piece on ways to improve your profit margin.
What is your profit margin?
In simple terms, profit margin measures how efficiently you turn revenue (money coming into your business, typically through sales) into profit (money made on top of your costs).
A low profit margin means that a lot of the money your business brings in is spent on costs, be that the cost of the goods you sell, the wages of your employees, your equipment, utility bills, maintenance, insurance etc.
A high profit margin means that your business easily covers its operating costs and has money left over to reinvest. It is a sign of good financial health if your profit margin is high.
How is a profit margin calculated?
There are multiple standard ways to calculate the profit margin of your business, though they all boil down to the same thing: expressing your profits as a percentage of your revenue. All that changes is how accurately you calculate your profits based on the costs you include.
Gross profit margin
This is the simplest calculation where you only subtract the costs of goods (COGS) sold from your revenue, and divide that by your revenue. The costs of goods sold includes any costs directly involved with making and selling your product: manufacturing, transportation, storage etc.
These costs will be higher for companies creating and shipping their own physical products, and low for businesses that instead provide services, like consultancies.
A typical calculation for gross profit margin might look like this:
(£80,000 revenue – £60,000 COGS) / £80,000 revenue = 25% gross profit margin.
Operating profit margin
This next formula adds further precision by adding in the operational costs of your business. These are your variable costs involved in managing and maintaining your business: rent, marketing, insurance, IT equipment, and the like.
A typical calculation for operating profit margin looks something like this:
(£80k – £60k – £5k operational costs) / £80k = 18.75% operating profit margin.
Net profit margin
Now we factor in further costs to get the most accurate picture yet of your business’s true financial wellbeing. Net profit also includes any tax or interest on loans that your business might have. If we add £6,000 of tax and interest into our equation, that means our final calculation will look like this:
(£80k – £60k –£5k – £6k tax and interest) / revenue = 11.25% net profit margin.
What’s a good profit margin?
It’s difficult to give a definitive answer on what constitutes a good profit margin without a more thorough understanding of your business and its unique circumstances. The sector it’s in will play a big role, as business with significant physical demands, like brick and mortar stores, will have much higher costs than a company run purely online.
For retail businesses, a profit margin between 3 and 5% is fairly typical, while manufacturing businesses might be higher at 9%, with service companies running around 15%.
If your company is just an app, you might have almost no costs and most of your revenue will be pure profit, recording profit margins of 50% or more! Most businesses though will have higher costs and so can expect lower profit margins while still being healthy and secure within their industry.
Not happy with your business’s profit? In next week’s post, we’ll look at ways you can improve your profit margin. See you then.