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How do you know if your business is successful?
It sounds like a simple question, but it’s one that most small business owners aren’t sure how to answer.
You know you’re in business to make money.
And while you’re certainly bringing in revenue, you know that you’re also spending a lot of money on supplies, labor, equipment, and other costs to keep your business running.
So, is your business successful? Is your bank account growing? Are you earning more revenue than you’re spending on expenses?
Accountants answer these questions—and more—by calculating your business’s net profit margin.
If you’re ready to measure your own business’s success, read on to learn everything you need to know about the net profit margin and what it means for your business.
Before we dive too far into all you need to know about your net profit margin, it’s important to know the different types of profit margins you might come across in your software-generated accounting reports.
Not all types of profit are created equal, or equally reflect your business’s true profitability.
So let’s have a quick review of the two main types of profit you’re likely to come across: net profit and gross profit.
If you use accounting software like Quickbooks Online, Freshbooks, or Wave Accounting, the software will calculate these figures for you.
Even so, it’s important to understand the formulas behind these numbers in order to have a full picture of where your net profit margin comes from, so we’ll also review the formulas behind each of these types of profit.
Simply put, a company’s gross profit is the profit it makes after deducting the costs directly associated with making its products or providing its services.
But for novice entrepreneurs, this term can often be confusing and misleading, since it leaves out some important costs associated with running a business.
For example, it doesn’t include wages for the bookkeeper who sends your invoices and runs your payroll, the cost of the janitor who cleans your office after hours, or even the income and employment taxes you pay to federal, state, and local government.
So let’s take a look at exactly how your gross profit is calculated, keeping in mind that it won’t be a totally accurate reflection of your business’s profitability:
Gross Profit = Revenue – COGS
The total amount of income your business brings in through sales of products and services and invoice payments received over a given period—usually listed as monthly, quarterly, or annual.
This acronym stands for “cost of goods sold” and refers to all expenses that you can fully and directly attribute to the production of goods sold by a company.
If you operate a retail company, this will include the cost of inventory sold in your store.
For service-based business, it’s the cost of paying an individual for the time they spent performing work for the client.
A company that manufactures a product would include the cost of raw materials that go into the product in their cost of goods sold.
Of course, any veteran entrepreneur will already know that a lot more goes into the costs of doing business than just the expenses that go directly into creating your product or providing your service.
Things like payroll, rent, taxes, office supplies, credit card fees, and much more all stack up to mean that your gross profit does not in any way translate to a bunch of extra money in the bank.
For this reason, accountants and financial managers use this net profit formula to paint a more accurate picture of your business’s actual profitability:
Net Profit = Revenue – COGS – Operating Expenses – Interest and Taxes
(You’re already familiar with the first two parts of the net profit formula from earlier.)
But going beyond the basics of your gross profit value, net profit also subtracts two other liabilities to create a more accurate picture of your actual profit earned.
Let’s get a handle on those two other parts of the formula:
These are the costs associated with operating your business that are not included in your costs of goods sold.
Operating expenses include things like payroll for administrative workers, rent on a retail space, insurance premiums, loan interest payments, and more—also usually listed as monthly, quarterly, or annual.
Before we go any further, it’s important to note the distinction between cost of goods sold (COGS) and regular operating expenses, since this difference impacts the accuracy of your gross profit vs. your net profit margin.
As you read above, cost of goods sold includes only those expenses that are fully and directly attributable to the production of your offering.
However, there are many areas where the line between COGS and operating expenses can be a little blurry.
For example, say you have an employee who spends half their time working in production on a product for customers—that is, physically assembling the product to be sold—and the other half of their time on research and development of future products. You could include a portion of that employee’s salary into your COGS. But for accuracy, it’s important that only the percentage of the employee’s salary proportionate to time spent producing goods is included in COGS.
Loan interest payments that are incurred during the period you’re reviewing are considered operating expenses, but payments of loan principal are not operating expenses. Loan principal payments appear on your balance sheet and statement of cash flows, but they shouldn’t be considered for purposes of calculating your net profit margin. Similarly, loan amounts that you receive from a bank are not considered revenue and shouldn’t be used to calculate net profit margin.
Interest and Taxes
This includes federal, state, and local income and payroll taxes, as well as any interest owed on business debt—like a business loan.
Together, your cost of goods sold, operating expenses, and interest and taxes should represent all of the liabilities on your profit and loss report for a given time period. Before you go to calculate your net profit margin, make sure that you’ve factored in any and all expenses.
From the formula above, you can figure out that net profit is the dollar amount of revenue from a given time period that remains after all expenses from that same time period get deducted.
The net profit margin is simply the ratio—usually expressed as a percentage—of net profit compared to the total revenue.
Here’s how the net profit margin is calculated:
Net Profit Margin = Net Profit / Revenue
Now that we’ve reviewed what each of these terms mean, their formulas, and how they work, let’s illustrate each of these steps with an example.
We’ll use the following calculations for Bella’s Bobbles, a fictional business that handmakes fashion jewelry pieces for wholesale, to help you understand how you can calculate and apply these formulas to your own business.
For the purposes of our calculations, let’s assume that all numbers are annual figures for fiscal year 2015:
Revenue = $100,000
Cost of Goods Sold (COGS) = $45,000
Remember that COGS includes only the expenses that can be fully and directly attributed to the production of the product.
In this case, that will include the costs of beads, wire, fasteners and other small supplies, packaging materials, and shipping costs for the finished pieces, as well as wages for one part-time employee who works exclusively on making the jewelry.
Using just the numbers above, Bella can calculate her gross profit as well as her gross profit margin:
Gross Profit = Revenue – COGS = $100,000 – $45,000 = $55,000
Gross Profit Margin = Gross Profit / Revenue = $55,000 / $100,000 = 0.55 or 55%
A 55% profit margin? Sounds like Bella is doing pretty well for herself! Right?
Remember that this is only the gross profit margin—and doesn’t actually represent all of Bella’s expenses.
Let’s get the rest of the calculations factored in to calculate Bella’s net profit margin. This will be a much more accurate representation of how Bella’s Baubles is doing financially.
Here are the additional figures we’ll need:
Operating Expenses = $38,000
This figure includes all of Bella’s costs of doing business that aren’t included in her COGS.
For Bella, that includes her small monthly owner’s draw, rent on her studio space, payment for her tax accountant, licensing costs for her accounting and point of sale software, and a budget for new and replacement tools needed for making the jewelry.
Taxes and Interest = $14,000
In addition to paying federal, state, and local taxes, Bella also pays interest on a small loan she took out last year to purchase tools and raw materials and to establish a studio space. The interest payments are included here, under taxes and interest.
Using these new figures, let’s calculate Bella’s net profit and net profit margin.
Net Profit = Revenue – COGS – Operating Expenses – Interest and Taxes = $100,000 – $45,000 – $38,000 – $14,000 = $3000
Net Profit Margin = Net Profit / Revenue = $3,000 / $100,000 = 0.03 or 3%
Factoring in all of these additional costs of doing business paints a very different picture of Bella’s profit margin.
Although her business is still turning a profit, a profit margin of 3% is much slimmer than what the gross profit margin conveyed.
Your net profit margin is often referred to as your business’s “bottom line.”
That’s because most financial experts see it as the end-all, be-all measurement of your business’s success:
A positive net profit margin means your business is profitable. The higher your net profit margin is, the more successful your business.
That said, it’s important to remember that the net profit margin is just one metric, and it doesn’t tell the whole story of how your business is doing. Of course a long-term negative profit margin isn’t a sign of success for your business—but no single figure should be viewed as the most or only important metric of how you’re doing as a business owner.
In fact, many business accounts would suggest that a business’s net profit margin isn’t nearly as important as its cash flow (or the total amount of cash transferred in and out of your business).
In order to be cash flow positive, you’ll need to have more money coming into your business than is going out at any given time.
As it turns out, you can be profitable without having positive cash flow—and you can have positive cash flow without being profitable.
But this distinction is important because cash flow challenges are the number one reason that most small businesses fail within the first 5 years.
And even with fantastic projections for your end-of-year net profit margin, short-term cash flow issues can still put your business at severe risk.
While every business wants a better net profit margin, it’s important to make sure the expectations you’re setting for yourself are realistic.
Net margins vary from company to company as well as industry to industry—and typical margins within your industry, even from relatively successful businesses—might be far lower than you think.
Wal-Mart, for example, made fortunes for its shareholders through net profit margins of less than 5% per year! On the other hand, certain companies within the energy and technology sectors enjoy net profit margins of 20% or more—so there’s no set benchmark that you should be measuring against.
It’s also worth noting that the phase your company is in could change reasonable expectations for your business’s profitability.
If your business is in a high growth mode, for example, it’s likely that most (if not all) of the company’s profits get immediately invested back into the business—so you won’t see those expressed as net profit margin on an accounting document, even though the business is growing and doing well.
Rather than seeking to meet a certain set margin, focus on improving your net profit margin quarter to quarter and year to year.
Then, even if your profitability takes a hit for a short period in the name of business growth, you can rest assured that this is a purposeful change and not due to poorly-controlled spending.
As you saw from the formulas earlier, the net profit margin isn’t a stand-alone figure that can be improved on its own.
Instead, it’s a ratio that reflects your net profit, which is a sum of various other business factors.
That means the only way to improve your net profit margin is to make changes to various pieces of the formula.
Here’s that formula again for your reference:
Net Profit Margin = (Revenue – COGS – Operating Expenses – Interest and Taxes) / Revenue
In order to find ways to grow your net profit margin, let’s break down the different ways we can make a change.
This one probably seems most obvious:
Of course, one of the fastest ways to increase your business’s profitability is by increasing your revenue!
But remember, it’s not quite that simple.
In order for your net profit margin to improve, you need to increase your revenue while also keeping all other expenses the same. If you have to spend a bunch of money in order to make any more, that’s not going to do much good for your profit margin!
In short, look for ways to increase your business’s revenue without changing your costs.
Could you increase prices? What about repurposing an existing product or service in a new and more valuable way?
This is all about using what you already have to generate more income.
From here on out, the focus turns to reducing your business’s expenses, starting with your cost of goods sold.
Remember, these are the costs that go directly into creating your product or service—including raw materials or inventory, packaging, shipping, and labor costs.
Have you shopped around lately to make sure you’re getting the best possible deal on raw materials for your product? Could you negotiate with your current vendors to get better rates by placing larger orders? Are there ways you could trim down the weight or volume of your packaging to reduce shipping costs?
These are line item expenses, so the savings might seem insignificant at first, but, over time, these reduced costs can have a significant impact on your net profit margin.
The large and nebulous category of general operating expenses is the most common culprit for most businesses’ profitability issues.
Over time you might add one or a few less-than-productive employees; spend more than you planned on travel, marketing expenses, or dinners out with prospective clients, or move into a new office or retail space that’s just a bit more than you can afford…
Suddenly, you’ve eaten into your bottom line with costs that aren’t even directly related to producing your product or providing your service!
If this scenario sounds familiar, now is the time to review your operating expenses with a fine-toothed comb.
Look at your last several months of credit card statements and expense reports, categorizing each and assessing the value of those costs.
Are those expensive client dinners and trips to conferences actually resulting in new business? Have your most costly marketing efforts met the ROI benchmarks you set? Do your employees’ productivity and effectiveness match the cost of their salaries?
If the answer is no—or even uncertain—it’s time to reconsider how you spend those dollars moving forward.
Finally, let’s look at your company’s spending on interest and taxes—the two areas that could feel most like you’re flushing profits down the toilet.
If you’ve taken on any business debt in the form of a loan, line of credit, or business credit cards, you’re probably paying some percentage of interest each month on that financing.
If you have the cash on hand, your best bet might be to pay back that financing as soon as possible, which—depending on your lending agreement—could let you save on interest. If you have multiple outstanding debts at various high interest rates, business debt consolidation may be a great way to find additional savings.
On the tax front, a good accountant can likely help you find ways to cut down your tax bill by finding additional tax deductions, taking advantage of incentives, or—in extreme cases—even moving your business to a more tax-friendly city or state.
As you look to make changes in any one of these categories, always keep in mind that your net profit margin is a balancing act. You want to improve one category without negatively affecting another, keeping everything balanced and your profitability growing.
If you’re not immediately impressed with your business’s net profit margin, remember: this is just one metric out of many that paint a total financial picture of your business.
But by keeping an eye on your business’s net profit margin, understanding how it’s calculated, and reviewing each element that goes into it, you’re already well on your way to measuring and achieving success for your small business.