Every business owner starts their venture with dreams of making it big! After all, doing something you're passionate about is exciting — and making a lot of money while doing it is the icing on the cake. 

So how can you be sure your hard work is paying off? 

Measure your business profit margins. Understanding your profit margins will help you operate your business more efficiently, plan pricing strategies, and reach your financial goals faster.  

To fully understand the financial health of your business, there are three types of profit margins to get familiar with: net, gross, and operational. Let's dive in and learn how to break down the numbers.

What Is a Profit Margin?

Profit margins are ratios that are used to determine business success. Your profit, or bottom line, is different from the actual revenue your business brings in each month or year. While revenue is all the money your business brings in before expenses, your profit is what’s left after you pay the expenses and costs needed to operate your company.  

As stated above, there are three types of profit margins that measure the difference between your business expenses and business revenue:

• Net profit margin

• Gross profit margin

• Operating profit margin

Your net profit margin reveals exactly how much profit is left over in your business after all expenses are paid, while your gross profit margin and your operating profit margin provide insight into what specific areas of your business are more or less profitable.

By measuring each type of profit margin, you can pinpoint exactly where any financial issues stem from, identify your company’s overall performance from multiple perspectives, and make plans to increase your profit margins sustainably.

How Do You Calculate Profit Margins?

The first step to optimizing profit margins is learning how to measure them. To calculate your profit margins, you must know your business revenue, expenses, and net income. (If you don’t know your net income, we’ll provide more information on how to calculate your net profit margin below.)

Net Profit Margin

Your net income, or bottom line, shows the amount of revenue left after all your expenses are deducted, including non operational costs such as taxes, one-time payments, and debt payments. 

Your net profit margin shows your company’s ability to make a profit overall, so it’s likely the margin you’ll want to start with. To calculate the net profit of your business, use the following formula:

Net Profit Margin = (Net Income/Revenue) × 100

If you don’t know your net income, you can use this more robust formula to calculate your net profit:

Net Profit Margin = [(Revenue – COGS – Operating Expenses – Other Expenses – Interest – Taxes)/Revenue] × 100

If your net profit margin is not a number that gets you excited, you can calculate your gross profit margin and your operational profit margin to identify areas where your expenses are highest.

Gross Profit Margin

Your gross profit margin is your business’s profit after deducting the cost of goods sold (COGS). The gross profit margin does not account for all business expenses — just the costs associated with the manufacture and production of items for sale. 

Gross profit margin allows you to see how profitable a sale of a single product or service is, but it doesn’t show the overall profit margin for the business as a whole. To calculate your gross profit margin, you can use the following formula:

Gross Profit Margin = [(Total Revenue – COGS)/Total Revenue] × 100 

If this profit margin is low, it’s likely that either your prices aren’t high enough or your manufacturing and production costs are too high.

Operating Profit Margin

Your operating profit margin, on the other hand, shows how profitable your business is after accounting for the operating expenses, sales expenses, and administrative costs needed to run your business. Keep in mind what the operating profit margin does not include — non operational costs such as debt payments and taxes. 

The operating margin numbers will give you an idea of what is left after paying all day-to-day operational expenses. To calculate your operating profit margin, use the following formula: 

Operating Profit Margin= (Operating Income/Revenue) × 100

As with your gross profit margin, your operating profit margin might reveal if any of your operating expenses are the main reason for a low overall net profit margin.

How to Determine If Your Profit Margin is Good

Just because you're making sales doesn't always mean your business is on the right track. By looking at each of the three profit margins, you can see where your expenses are too high to determine where you can increase profitability. 

According to NYU, 7.71% is the average net profit margin in the United States. However, different industries fluctuate on margin levels, so this is by no means the benchmark you should be aiming for in your business. Expenses, operating costs, size, location, and the length of time you’ve been in business all play a role in your target profit margins. 

In general, a healthy profit margin depends on the business and the industry you’re in. For creative agencies, average profit margins may be anywhere from 10-50%. It's important to note that even if you have a profit margin of 20% or higher, you still might not be making the most optimal decisions for your business.

Why It's Important to Understand Your Business Margins

Your profit margins give you a better idea of whether your business operations are profitable or if your expenses drain your profits. Better profit margins result in better returns, so it’s in your best interest to review your profit margins frequently. 

Creditors, investors, and businesses all use profit margins to measure business financial health and growth potential — so if you're planning on taking on investors, increasing the number of people you hire, or making another important financial decision in your business, you'll want to know your profit margins are sound.

How to Increase Your Profit Margins

If you need to increase your profit margins, there are several ways to do so. But keep in mind that the strategies you employ should be well-suited to the needs and capabilities of your unique offerings and business operations.

Many people assume that to increase their profits, they just need to make more sales. And while you likely do want to increase your sales to grow your business, an increase in sales doesn’t always mean more profit. 

In fact, making more sales results often results in higher overhead expenses or operating costs. If you don’t factor those costs into increased growth, you could actually end up decreasing your profit margins.

If that’s the case, you may need to consider increasing your prices to account for those higher expenses. Of course, you’ll want to be strategic about increasing your prices to avoid losing current customers or clients. And increasing prices isn’t the right strategy for every business.

Alternatively, you may be able to increase your profit margins by cutting costs in your business. For example, if your costs are high in one area, consider how you might automate various business tasks or processes in that area to decrease costs. Many software services are available to assist with tasks that can help bring your costs down.

Ultimately, you have several options available to you. You just have to analyze which options are right for you and your business.

Get Support With an Outsourced CFO

If you’re not happy with your profit margins and you don’t know how to go about increasing them, it’s time to bring in a professional. At Lamplight Advisors, we develop custom strategies for our clients to increase profit margins in a way that’s sustainable for future growth. To see how we can help you meet your projected profit margins and reach your financial goals, click here to schedule a conversation today.