How Do You Calculate Profit Margin for Your Startup? Here’s the Equation.
To calculate the Gross Profit Margin for your startup or small business, take the revenue and minus the direct costs of producing your product. Divide this by the revenue. The resulting number is multiplied by 100 and the answer is expressed as a percentage. This is your Gross Profit Margin.
Here’s What We’ll Cover:
What Is Profit Margin?
Profit Margin is a number that reflects your small business or startup’s profitability. There are a four different kinds of profit margins:
Gross Profit Margin (or Gross Margin)
This refers to the cash left over in your business after accounting for the direct costs (such as materials and labor) to produce your product. These direct costs are known as “Costs of Goods Sold”.
The Gross Profit Margin is important because it tells a business owner if the company sales are good enough. It is also a good metric in that it allows for comparison to competitors, because companies with better gross profit margins (in the same industry) are likely to have more efficient operations in place.
Gross Profit Margin calculation:
(Total Revenue - Cost of Goods Sold)/Total Revenue x 100
Operating Profit Margin
Unlike Gross Profit Margin, the Operating Profit Margin includes operating expenses (like administration costs) in the equation. This figure is calculated without interest or tax. The Operating Profit Margin shows how well a company is allocating its resources.
Operating Profit Margin calculation:
(Operating Income/Net Sales Revenue) x 100
Pre-Tax Profit Margin
The Pre-Tax Profit Margin allows one to know the profitability of a company before taxes are deducted. Comparing profit margin numbers over time indicates the direction the company is taking.
Pre-tax Profit Margin calculation:
(Earnings Before Taxes/Revenues) x 100
Net Profit Margin
Net Profit Margin is the percentage of revenue remaining after all deductions. These deductions include operating expenses, taxes, interest and stock dividends. A positive number reflects that the company makes more money than it spends, a negative number shows that spending is outpacing profitability.
Often this number is referred to as ‘the bottom line’.
Net Profit Margin calculation:
(Operating Profit - Interest Expenses - Tax Expenses)/Revenue x 100
How Do You Assess a Company's Profitability?
Profit margins, as outlined above, are a good place to start with assessing your company’s profitability. Comparing these numbers over time helps management to know if the company is meeting expectations when it comes to profitability. Keep in mind that depending on the industry and a company’s particular business plan, profitability may take some time to achieve, perhaps even years.
What Is a Good Profit Margin for a New Business?
A good profit margin for a business really depends on the type of business you’re in. Profit margins are industry specific.
Let’s give an example. Say you work in the video game industry, running a small business that makes video games. It’s been a rough couple of years but you’ve established yourself and business has really picked up. Your accountant runs the finances and tells you that the “net profit” margins for your company is 12% (this is the percentage of revenue remaining after all deductions). The question isn’t “is this percentage good or bad?”, the question you should be asking is this: “Is this percentage good or bad for my industry?”. Well, when checked against profitability margins by industry, the average for “entertainment software” for the year turns out to be 16%. So, not bad.
But that’s “entertainment software” and it has a whole set of financial challenges unrelated, to say, the restaurant industry. In fact, you contact your friend Freddie who runs a small bistro downtown. He tells you his “net profit” margins are at 12% too. But for his industry - that’s good (in fact, he’s doing better than the “restaurant” net profit margin average of 10%). But again, you’re in different industries, with different requirements.
Remember that doing these calculations doesn’t show how much money you could be making, only how much is actually made (on each dollar of sales). By comparing it to the industry standard, you can see if there’s a way to reduce your operating expenses because others in the same industry are able to do it.
How Do I Increase Profit Margins?
We’ve shown you what goes into the profit margin equations. To get better results, the key is to increase your revenue numbers or decrease your expenses. Consider:
Increasing Your Product’s Pricing
Can this be done? Will customers still buy if you increase your selling price? Consider the demand for your product and if even a small increase will be acceptable in the market.
Assessing Your Existing Customer Base
What are your existing customers buying from you right now? Do they need more or similar products and services that you can provide? Consider what you can offer them, as the relationship is already there. You’ve already got a foot in the door.
Reducing Your Product Lineup
Does the research tell you that some of your products are selling way better than others? Is this a trend that shows no signs of changing? Do these low selling products take more to produce in labor, machinery, etc.? Consider dropping what’s not profitable enough, to help your bottom line.
The longer you’re in business, the more opportunities are going to present themselves to streamline operations. Are there ways to increase efficiencies so that you can output at the same level with less production? Is there any unnecessary “waste” in regards to production? Best to include your senior guys in this analysis and explain the rationale, and consider new ways of doing things, like automation or farming some parts of the process out. There might even be a simple solution that will speed up production time, meaning less labor and machine costs.
Re-Assess Your Marketing Strategy
How much do you spend on marketing your product, and how much do you understand about the process and the costs involved? These costs can be high depending on the marketing channels you’re using. Reassess what the marketing is actually bringing in, in ways of dollars, and if there are other, more cost-effective ways of reaching your client base.
Cut Some Clients
Are some clients taking up too much time? Are they so difficult that they actually cost you money with unnecessary service do-overs or product replacements? You probably hate the thought of losing a client - any client - no matter how difficult they are, but consider what this is costing you.