Your company’s profit margin is one of the most important figures you need to look at while trying to grow your company. The calculation is simple—just divide your profit by your revenue.
And yet, this one metric is critical.
It’s critical because it shows how good a company is at handling its finances. It tells you the percentage of sales that have made a profit for the company. In other words, the profit margin shows how many cents of profit was generated with each dollar made through sales.
When calculating your company’s profitability, you always need to consider the two most important types of profit margin: gross profit margin and net profit margin.
In this article, we’ll cover these two types of profit margin, why they’re important, and how to increase them long-term. Keep reading if you want to learn more about using profit margin to grow your medium or small business.
Gross profit margin
Gross profit margin is a metric used to calculate the amount of money that’s left after deducting the cost of goods sold (COGS). It’s normally used to determine a company’s financial health.
The gross profit margin is also expressed as a percentage of sales. That’s why accountants often call it the gross margin ratio.
Gross profit margin formula
To calculate gross profit margin, you need to deduct the COGS from total sales.
The gross profit margin formula is the following:
Gross profit = total sales – cost of goods sold
On the other hand, if you want to get the gross profit percentage (ratio), you can apply this formula:
Gross profit percentage = (total sales – cost of goods sold) ÷ total sales
Gross profit margin example
To better understand the calculation, take a look at this gross profit example.
Let’s say that your company has $1,000,000 in total/gross sales and $350,000 in cost of goods sold.
When we apply the two formulas, it looks like this:
$1,000,000 – $350,000 = $650,000
($1,000,000 – $350,000) ÷ $1,000,000 = 0.65 (65%)
In this case, your company’s gross profit margin would be 65%. In other words, it would make 65 cents for every dollar of sales.
What does gross profit margin show?
The company’s gross profit margin is the first of several layers of its profitability. Business owners use it to assess the company’s performance.
- Gross profit shows how good a company is at creating a product or offering a service compared to its competitors.
- Since it’s calculated as gross profit divided by revenues, this figure allows for comparing business models with a quantifiable metric.
- Gross margin shows a company’s overall financial health.
How to use gross profit margin
As one of the crucial financial ratios, the gross profit margin ratio is used to compare business models with competitors. Industry-leading companies often have a higher gross profit margin, while a struggling business would have a low profit margin.
If your company sells the same type of product for the same price as your competitor but makes it for half the cost, you will have a higher gross profit.
And if your competitor tries to increase its gross profit by doubling the price of its product, it can easily backfire on them. Due to the higher selling price, the demand for their product could decrease and so could the company’s gross profit margin.
Therefore, increasing the product price doesn’t always help companies increase revenue.
Net profit margin
The net profit margin shows how much profit a company generates from sales. It is generally expressed as a percentage and shows what part of a company’s net income (bottom line) translates into profit.
In other words, this figure will help you see what percentage of each dollar earned by your company turns into profit by the end of the year.
Generally speaking, the net profit margin is regarded as more important than the gross profit margin. A company can determine whether its practices are working and forecast profits based on revenues by simply tracking increases and drops in its net profit margin.
Net profit margin formula
To calculate a company’s net profit margin ratio, we need to divide the net profit by total sales.
For this, we use the following formula:
Net profit margin = net profit ÷ total revenue
Net profit margin example
If your company has $30,000 in net profit and $100,000 in revenue, the profit margin calculation would look like this:
$30,000 ÷ $100,000 = 0.3 (30%)
What does net profit margin show?
The net profit margin is one of the biggest indicators of a company’s financial health. Investors usually use the net profit margin to assess how efficiently a company is being managed and predict how profitable it will be in the future.
A low net profit margin means the company isn’t profitable, while a high net profit margin shows that the company’s profitability is improving.
Keep in mind that net profit margins are expressed in percentages, so they can be used to compare the profitability of any two or more businesses, no matter their size.
How to use net profit margin
The net margin measures the company’s overall profitability. It takes all financing and operating expenses of the company into account and gives us a percentage of the revenue that’s left.
This revenue can be used for various corporate activities, like paying back the money invested by shareholders or reinvesting in the business.
By itself, the net margin has some faults since it considers the interest payment and the tax shield from interest payment. That’s why sometimes it’s better to use operating profit margin.
Nonetheless, net margin is a useful tool when combined with other financial performance metrics.
5 ways to increase net profit margin
It’s in every company’s best interest to increase the net profit margin. You always need to keep a close eye on it.
A company’s profit margin shouldn’t be static. Instead, it should always be rising and improving if the company is thriving.
You can increase net profit margin by either reducing production costs and business expenses or increasing the sales revenue.
1. Reduce utilities
Did you know that you can save as much as 10% per year on cooling and heating by slightly decreasing the temperature on your thermostat? Sure, reducing utilities might seem too difficult at first, but there are ways to spend less money in this area.
Here are some tips to reduce utility use:
- Limit power consumption by turning off devices that idle in standby mode overnight.
- Reduce the amount of water consumption by checking your faucets for leaks, and if you have any office bathroom renovations planned, install low-flow toilets.
- Turn down heating and cooling 7-10 degrees outside of business hours.
2. Reduce labor costs
Your company might be spending more on labor than necessary. A lot of companies can make improvements when it comes to labor costs.
Take a look at the following tips if you want to decrease labor costs:
- If your employees have a lot of overtime work, cut it down. Since overtime is paid more than the regular rate, it’s more profitable to schedule employees in such a way that nobody is working more than needed.
- Before hiring more workers, see if your employees can take on more tasks. Organize a meeting to discuss additional tasks and see if anyone has time for them.
- Use contract-based workers whenever possible. Jobs like data entry, app development, or even marketing are often outsourced with great success.
3. Decrease operating costs
It’s possible that you have high operating costs because you don’t see how to reduce them efficiently.
Try these tips to lower operating costs:
- Expensive supplies can greatly increase operating costs. To fix this, see if you can buy common items in bulk to get a discount.
- Check with your vendors to see if they will give you a discount for paying bills early.
- See if there are cheaper ways to do administrative tasks. Use software tools like Zapier or Oracle to offload and automate some repetitive tasks to free up the manpower.
4. Lower your prices
If you don’t want to cut down on total expenses to have a good profit margin, you need to increase your revenue by selling more products.
Here are some tips to follow:
- Implement pricing strategies such as reducing your prices or running occasional sales.
- Be careful not to reduce the price too much or it will result in a smaller net profit margin.
There is no definite answer as to how much you should decrease your prices, as it all depends on your products, services, and industry. However, you could experiment with a group of customers to see what price will best resonate with them.
5. Increase your prices
A contrasting pricing strategy you can apply is increasing the selling price of your products. As long as the customers are buying the same number of products but spending more money, your net profit margin will rise.
However, just like with the previous tip, you need to be careful about how much you increase your prices. If you go overboard, fewer people will want to buy the product and your profit margin will ultimately decrease.
Here are some strategies you could use according to Inc.:
- Be careful how often you raise prices. The best practice is to increase the price once a year, and only if it’s necessary.
- Raise the price in small increments until there’s negative feedback. As long as you provide good value, try slightly increasing prices once in a while until your customers show resistance.
- Recognize when to increase prices. If your new customers seem too happy with your prices, then you’re probably undercharging.
- Monitor your competitors day-to-day and look at their historical trends. However, don’t always try to price-match them, since your best best is to beat them on value.
Putting profit margin to use
Profit margin, especially net profit margin, is extremely important when trying to determine your company’s financial health. However, you don’t always have to make drastic changes to improve this indicator.
Sometimes, simple steps like lowering utility bills or slightly increasing selling prices can result in a higher net profit margin and a better bottom line.