|What is a Good Profit Margin? Industry Averages and how to Improve Yours|
Profit margin, as its name implies, represents the remaining funds after subtracting startup expenditures. It serves as a percentage, measuring the effectiveness of your pricing strategy, cost management, and the efficiency in utilizing raw materials and labor for your product or service production.
After grasping the concept and significance of profit margin, the subsequent inquiry naturally becomes, “What is a good profit margin for a small business?” The response fluctuates depending on factors such as geographical location, industry sector, business model, company age, and growth objectives.
It's important to note that significant economic occurrences, such as the COVID-19 shutdown, typically lead to a reduction in profit margins across all companies.
Here, you will discover three formulas for calculating profit margin, a convenient compilation of typical profit margins categorized by industry, and suggestions to enhance your profit margins.
Types of Profit Margin
Business owners, accountants, lenders, creditors, and investors depend on three distinct profit margin types. You can assess your company's gross profit margin, operating profit margin, or net profit margin.
These three formulas offer distinct perspectives on your financial well-being, aiding in making informed business choices. Delve into our detailed explanations of each margin to gain a deeper understanding.
1. Gross Profit Margin
Gross profit represents the revenue remaining once the cost of goods sold (COGS) is subtracted. COGS encompasses the expenditures required for the production or manufacturing of your goods or services, such as raw materials, factory overhead expenses, and labor wages.
You can calculate gross profit using the following formula:
Gross profit = revenue – cost of goods sold
Once you've computed your gross profit, you can ascertain the gross profit margin through this equation:
Gross profit margin = (gross profit ÷ revenue) x 100
Gross Profit Margin Examples
Question 1: Company X generated $500,000 in revenue and had $300,000 in cost of goods sold (COGS) for the same period. What is the Gross Profit Margin for Company X?
Gross Profit Margin = (Gross Profit ÷ Revenue) x 100
Gross Profit = Revenue - COGS
Gross Profit = $500,000 - $300,000 = $200,000
Gross Profit Margin = ($200,000 ÷ $500,000) x 100 = 40%
Answer: The Gross Profit Margin for Company X is 40%.
In most cases, the gross profit margin provides a more precise measure of the profitability of individual items rather than the entire business as a whole. While a business with impressive total sales may appear robust at first glance, it could, in fact, be experiencing losses if it doesn't take into account high operating expenses.
The calculation of gross margin can reveal whether you're allocating excessive time or labor to a particular product or service.
2. Operating Profit Margin
Operating profit represents the earnings that remain once you've subtracted both the cost of goods sold (COGS) and operating expenses (OPEX). As mentioned earlier, COGS pertains to the direct expenses associated with producing your products or services.
In simpler terms, operating expenses are the costs you need to pay to keep your business running smoothly. These are things like rent for your space, paying your employees, money spent on marketing, and software to manage your products. These expenses are necessary to keep your business going.
Expenses such as paying interest and taxes are not counted in these costs.
Start by figuring out your operating profit:
Operating profit = Revenue - Cost of goods sold - Operating expenses
After calculating your operating profit, you can use this formula to find the operating profit margin:
Operating profit margin = (Operating profit ÷ Revenue) x 100
Operating Profit Margin Example
Question 2: Company XYZ generated $1,000,000 in revenue, had $300,000 in cost of goods sold (COGS), and incurred $400,000 in operating expenses. What is the Operating Profit Margin for Company XYZ?
Calculate Operating Profit:
Operating Profit = Revenue - COGS - Operating Expenses
Operating Profit = $1,000,000 - $300,000 - $400,000 = $300,000
Calculate Operating Profit Margin:
Operating Profit Margin = (Operating Profit ÷ Revenue) x 100
Operating Profit Margin = ($300,000 ÷ $1,000,000) x 100 = 30%
Answer: The Operating Profit Margin for Company XYZ is 30%.
For a more comprehensive and precise overview, it's advisable to rely on either the operating profit margin or the net profit margin.
3. Net Profit Margin
Net profit is the money left over after you subtract the cost of goods sold (COGS), operating expenses (OPEX), interest, and taxes from your revenue.
To calculate your net profit, use this formula:
Net profit = revenue – cost of goods sold – operating expenses – interest – taxes
Once you have your net profit, you can find the net profit margin using this formula:
Net profit margin = (net profit ÷ revenue) x 100
Net Profit Margin Example
Question 3: Company ABC had total revenue of $1,200,000, cost of goods sold (COGS) of $400,000, operating expenses of $300,000, interest expenses of $50,000, and paid $80,000 in taxes. What is the Net Profit Margin for Company ABC?
Calculate Net Profit:
Net Profit = Revenue - COGS - Operating Expenses - Interest - Taxes
Net Profit = $1,200,000 - $400,000 - $300,000 - $50,000 - $80,000 = $370,000
Calculate Net Profit Margin:
Net Profit Margin = (Net Profit ÷ Revenue) x 100
Net Profit Margin = ($370,000 ÷ $1,200,000) x 100 = 30.83%
Answer: The Net Profit Margin for Company ABC is approximately 30.83%.
The net profit margin is one of the most reliable indicators of a company's profitability because it considers both direct and indirect costs incurred by the business over the period under review.
Anticipate Differences In Your Gross, Operating, And Net Profit Margins
To demonstrate the differences between the margin formulas, let's examine Amazon's margins as of March 2020:
- Gross profit margin = 26.06%
- Operating profit margin = 5.29%
- Net profit margin = 3.36%
With each margin calculation, a bit more of your company's expenses are taken into account, which means your profits are likely to decrease as you move from one formula to the next. However, your business might experience a less significant decline when transitioning from gross profit margins to the other two margins.
Consider that a highly profitable global corporation like Amazon will have operating expenses and other expenditures that significantly surpass those of most startups. Consequently, they can anticipate their operating and net profit margins to be slimmer.
What is a Good Profit Margin?
According to an NYU report on U.S. margins, the average net profit margin across various industries stands at 7.71%. However, it's important to note that your ideal profit margin may not necessarily align with this figure.
As a general guideline, a 5% margin is considered low, 10% is seen as a healthy margin, and 20% is regarded as a high margin. However, it's important to understand that adopting a one-size-fits-all approach may not be the most effective way to establish profitability goals for your business.
To begin, certain companies are naturally predisposed to be high-margin or low-margin enterprises. Take, for example, grocery stores and retailers, which tend to be low-margin. They incur substantial costs because they must procure inventory, hire both corporate staff and laborers, manage shipping and distribution, and secure larger facilities as their sales expand.
However, products with low profit margins, such as food and certain consumer goods, are typically easier to sell. Additionally, a fiercely competitive market, such as the rivalry between Uber and Lyft in the rideshare industry, can also lead to slim profit margins.
On the other hand, enterprises like consulting firms and software-as-a-service (SaaS) companies typically enjoy high gross margins. Such businesses have lower operating expenses, no need for inventory, and demand less initial capital for their establishment. High-value product companies, such as jewelry stores, can also fit into this category.
The age and size of a business also influence profit margins. New businesses often boast higher profit margins compared to larger, well-established firms. Typically, there are fewer sales, a smaller workforce, and consequently, lower overhead expenses in the early stages. However, as operations expand, profit margins tend to decrease.
The geographic location can significantly impact profit margins for businesses in the same industry. For instance, a tech company in San Francisco will face vastly different rental and payroll expenses compared to a tech company in Dallas.
Ultimately, what constitutes a favorable profit margin depends on your growth objectives. If you intend to attract investors in the near future, require financing for significant equipment acquisition in the current quarter, or have ambitions to broaden your services, you'll need to boost your margins. Stay tuned for upcoming tips on how to achieve this.
Average Profit Margins by Industry
Your profit margin serves as a benchmark for evaluating your business's performance relative to competitors in your industry.
While there isn't a universal target, a good profit margin often falls within the range of 5% to 10%. Below, in alphabetical order, you'll find a compilation of net profit margins for various common business sectors:
- Advertising: 3.30%
- Apparel: 5.87%
- Auto and truck: 3.04%
- Auto parts: 3.05%
- Beverage (alcoholic): 7.94%
- Beverage (soft): 18.50%
- Brokerage and investment banking: 17.62%
- Building materials: 4.30%
- Business and consumer services: 3.83%
- Computer services: 4.34%
- Drugs (pharmaceutical): 18.38%
- Education: 9.59%
- Electronics (consumer and office): -3.14%
- Electronics (general): 5.70%
- Engineering and construction: 1.00%
- Entertainment: 11.73%
- Farming and agriculture: 2.47%
- Financial services (non-bank and insurance): 26.94%
- Furniture and home furnishings: 5.15%
- Healthcare products: 9.27%
- Household products: 4.73%
- Information services: 19.13%
- Insurance (general): 6.26%
- Investments and asset management: 21.06%
- Office equipment and services: 4.91%
- Publishing and newspapers: -1.64%
- REIT: 15.17%
- Real estate (development): 6.65%
- Real estate (general and diversified): 19.75%
- Real estate (operations and services): 3.59%
- Recreation: 1.15%
- Restaurants and dining: 10.57%
- Retail (general): 2.44%
- Retail (grocery and food): 1.44%
- Retail (online): 4.57%
- Shoe: 10.48%
- Software (entertainment): 20.53%
- Software (internet): 2.07%
- Software (system and application): 19.54%
- Transportation: 3.79%
If you don't find your industry listed above, please refer to the complete list on the U.S. Margins by Sector page. There, you can find more financial metrics, such as gross margin, operating margin, and more for each sector.
4 Best Ways to Improve Your Profit Margin
Boosting profitability involves either increasing revenue, cutting costs and expenses, or a combination of both. Here are some tips to help you reach your desired profit margin:
1. Reduce your overall operating costs
These encompass expenses like office space and utilities, materials and supplies, payroll and benefits, employee expenses, insurance, equipment maintenance, shipping costs, and business software. Endeavor to negotiate for lower rates, consider downsizing, or eliminate any superfluous services to reduce these costs.
2. Remove underperforming products or services, or add higher-margin alternatives
Do a break-even analysis to determine the real profitability of a product. You copy other companies in your niche or research on high-margin products specific to your sector. Regardless of the approach you take, it's essential to carefully assess the cost of goods sold and operating expenses in relation to your target selling price.
3. Modify your pricing approach
Try changing how much you charge for your product. Test different ways of deciding the price, like thinking about what customers value (value-based pricing) or adding up all your costs and adding some more (cost-plus pricing). You will be shocked at how this affects how many people want to buy your product.
4. Build brand loyalty
Frequently connecting with your customers and expressing gratitude can directly boost sales and keep customers coming back. Keeping more customers means spending less on advertising.
Conclusion: What is a Good Profit Margin?
The profit margin tells you a lot about a business. It shows how much money it's making, how stable it is, and if investors might be interested in it. You can also use it to see how you are performing against your competitors and check if your business plan can last over time.
But if you're not at that point yet, don't fret. Apply the tactics mentioned earlier and think about reaching out to a financial advisor for personalized help.