Of course, money is not everything. But, for startup founders, it’s the top priority. You can tell sellers, investors, and loan officers that you want to make a difference in the world, but they will be more interested in financial metrics, especially your profit margin. If your business is new, there are a number of factors to consider before you understand what your ideal profit margin should be.
- When it comes to measuring profitability, gross profit margin is a good way to determine the profitability of a particular product, but net profit margins are a better measure of overall profitability.
- Net profit margin is critical because it measures total sales, minus business expenses, and then divides that number by total revenue.
- The best net profit margin for your business depends on the industry you are in; It is useless to compare your margins with a company in a completely different industry.
- In some cases, newer companies will have better profit margins than older companies, because as sales increase, so does the cost of manufacturing the products or providing the services.
Net Margin vs Gross Margin
There are two types of profit margins. Small business owners use gross profit margin to measure the profitability of an individual product. If you sell a product for $50 and it costs you $35 to produce, your gross profit margin is 30% ($15 divided by $50). Gross profit margin is a good number, but it’s likely to be ignored when considering your business as a whole.
Net profit margin is your choice of metric for a company’s profitability, because it looks at total sales, subtracts business costs, and divides that number by total revenue. If your new business generated $300,000 last year and cost $250,000, your net profit margin is 16%.
Let’s say you are a bakery. You make some of the best wedding cakes in the city. He kept very good records and after doing the math, he came up with a net profit margin of 21%. Your friend owns an IT company that installs complex computer networks for businesses and has a net profit margin of 16%. Are you a better business owner because your profit margin is five percentage points better? It doesn’t really work that way because markup is industry specific.
Business owners earn a higher margin in some sectors compared to other sectors due to the economic factors of each industry. For example, if you are an accountant, you might expect margins of 19.8%. If you are in the food service business, you may only see 3.8% net margins. Does that mean you should sell your bakery and become an accountant? Profit margin does not measure how much money you make or could make, but rather how much you actually make for each dollar of sales.
If you’re a consultant, your margins will probably be quite high since you don’t have a lot of overhead. It cannot be compared to a manufacturer that rents space and equipment and has to invest in raw materials.
Net profit margins vary by industry and cannot be compared: By nature, industries in the financial services sector, such as accounting, have higher profit margins than industries in the food service sector, such as restaurants.
New company vs mature company
Many new business owners believe that you should expect a lower profit margin at first. Of course, it depends on your field, but, in most cases, this is not surprising. In the service and manufacturing industries, profit margins decline as sales increase. The reason for this is simple: companies in these sectors could see a 40% margin until they reach around $300,000 in annual sales. That is the time when the company needs to start hiring more people. Every employee in a small business drives the lowest margins.
The bottom line
First, when a business is small and simple, margins are likely to be very good. It does not have a large workforce or other substantial overhead. As your sales increase and your business grows, more money comes in. But your margins are likely to decline as you are more likely to hire more people, invest in more facilities, and expand your product line. It is only necessary to make more profit if you put in more money.
And as your business expands, keep leaning into your margins. More sales numbers are great, but make sure you make the most money from those sales.