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The profit margin formula is net income divided by net sales. Net sales is gross sales minus discounts, returns, and allowances. Net income is total revenue minus expenses. A 10% profit margin is considered average.
Profit margin goes to the heart of whether your business is doing well. It shows what percentage of your revenue comprises profit, as opposed to business costs and expenses. In business finance, profit margin tells you how much you make on the sale of each product or service.
While it seems logical, there are many things small business owners either don’t know or forget about profit margins—including what your profit margin goals should be to begin with. You can use our helpful guide to assess good profit margin goals for your small business below.
Although there are slight variations on the definition, a profit margin typically represents the percent of revenue earned after all costs, business taxes, depreciation, interests, and other expenses have been deducted.
These are some reasons you should track your profit margins:
Once you have your profit margin, you can see how many revenue dollars are actually going to your bottom line, as opposed to covering your business expenses. The profit margin can also reveal whether you’ve priced your product too high or too low.
To calculate profit margin of a business, most organizations use the following formula:
Net income is total revenue minus business expenses. Net sales is gross sales minus discounts, returns, and allowances.
So, how do you calculate your small business profit margin?
It depends on what you’re trying to measure. According to the QuickBooks Resource Center, there are two types of profit margins that small businesses can measure:
How much do you calculate? In short, everything. In order to get an accurate look at what your small business’s profit margin is, you need to look at all the details.
You need to keep track of everything: from expenses like payroll, utilities, and shipping to every source of revenue, including the small stuff like transaction fees or maintenance contracts. This gives you a very clear picture of your company’s profit margins, so you have to be extra careful not to miscalculate or leave anything off the books. OmniCalculator is a great online tool for helping you determine profit margins.
The numbers that you need to calculate your profit margin will also show up on your latest profit and loss statement. If you need to update your income statement, you should be able to do so quickly with business accounting software.
A good profit margin very much depends on your industry and expansion goals and a host of other factors, like the economy. It can sometimes seem like comparing apples to oranges.
Industries with hardly any overhead costs, like consulting, for example, have higher profit margins than, say, a restaurant, which pays overhead costs in facilities, payroll, inventory, and so on. S&P 500 reports the blended net profit margin for Q1 2018 to be 11.6%. Profit margins above 11% outperform those of the market, but a profit margin under 15%-20% indicate vulnerability to negative market changes. Again, it’s hard to compare every small business against this average as all businesses are unique and operate differently.
See some factors that affect what makes a “good” profit margin below:
More example industry profit margins from the NYU study:
Of course, knowing what is a good profit margin and understanding your profit margin is the first step in improving your margins. Once you have that data, these are just a few ways you can help your business improve its profit margin:
Profit margins can be tricky—both determining them and understanding what’s right for your business. Do your research for your industry and make sure to track, track, track those numbers down to every last expenditure and revenue source. Knowing where you are with your profit margin helps you determine where to go next, and it’s different for every business.