While there are many ways to analyze the health of a business, the amount of profit generated is one of the best indicators of success for growing small businesses. For that reason, profit is king to many companies, and it’s tracked more closely than any other metric.
But aside from tracking total profit month-over-month or year-over-year, there are other ways to slice and dice profit. One of the most common ways to do so is by analyzing profit margins.
What Is Profit Margin?
Put simply, profit margin is a ratio comparing the total amount of profit you made to your total revenue. Basically, what percentage of your total sales did your company get to pocket after all expenses were paid?
You can examine profit margin for your company as a whole or you can break it down by product to see which of your products or services are more profitable than others. Establishing a baseline profit margin can help you make decisions about the direction of the company and which initiatives to go after.
How to Calculate Profit Margin
The formula for calculating profit margin is simple, as shown here:
Profit Margin = Net Profit / Net Sales
It’s important to note that net profit is also sometimes referred to as “net income,” and net sales can also be called simply “revenue.” The formula works with any combination of these terms as long as the total profit you have left at the end of a period is divided by everything you sold during that same period.
Both net profit and net sales can be found on your Income Statement (also known as a P&L Statement), which can be developed by an accountant or accounting software on a monthly, quarterly, or annual basis.
As an example, if a coffee shop brings in $50,000 in revenue one month and has $35,000 in expenses, their net profit will be $15,000.
$15,000 (Net Profit) / $50,000 (Net Sales) = 0.3 (Profit Margin)
In this scenario, the coffee shop’s profit margin is 0.3. If, however, they decided to upgrade the beans they sell and increase expenses to $40,000, the profit margin would shift to 0.2.
$10,000 (Net Profit) / $50,000 (Net Sales) = 0.2 (Profit Margin)
The spending decisions that companies make can have a big impact on profit margin, meaning that if margins are slim, it’s within the company’s power to make adjustments to help boost it.
How to Increase Profit Margin
If you’re dividing profit by sales, there are two fairly obvious ways to boost profit margin numbers: raise prices or spend less.
Raise Your Prices
Raising prices seems like a no-brainer for increasing profit margins, but it’s a tricky subject. Increased prices could isolate customers, resulting in lower sales that offset any gains from the increased price.
Before adjusting prices, perform a competitive analysis of other companies in your industry. The coffee shop, for example, should regularly visit similar shops nearby to make sure that their prices are in line with industry standards. If they are higher, they should consider whether customers expect higher quality at their own shop or if they’ll go elsewhere?
If, on the flip side, our coffee shop found they were charging less for the same quality experience, raising prices slightly might be a simple first step to increase profit margin.
Analyze Expenses & Make Cuts
The second no-brainer option for boosting profit margin is spending less. If your business can cut back on expenses without sacrificing the quality your customers expect, profits will go up.
Businesses have to spend money to make money. Even online businesses with minimal overhead still have to take labor costs into account. If you start making drastic cuts to your expenses, you run the risk of sacrificing quality, which your customers will notice.
Before buckling down on all spending, analyze the categories your company spends most on. If your business is spending money on ten different software subscriptions, look into how your teams are using them. If there’s overlap, you might try to consolidate the work to a few subscriptions or get rid of any that aren’t being utilized well.
Similarly, a bakery that places a bulk order on flour each month might see significant savings by negotiating the rate down or exploring new suppliers. It may not be a drastic discount, but the sheer amount of flour ordered could make it worth the effort.
Beyond simply charging more and spending less, there are several other ways to impact profit margin. One such way is to speed up production.
Some overhead expenses like rent and utilities are paid every month, no matter how much work you get done. If you’re able to shorten the time between purchase and delivery (and take on more work as a result), you’ll help to drive up your profit margin.
For the coffee shop example, this really means getting more customers in the door and being able to accommodate them. If customers are leaving because of long lines, an extra barista could help you serve more cups of coffee per hour.
But this concept is better applied to companies that invoice customers for work done over time. If your company designs websites and your team can build three new sites per month, consider what you can change operationally to bump that number up to four new sites per month. Where do your processes tend to break down? What can you do to smooth them out?
Avoid Churn at All Costs
For businesses with ongoing revenue, like long-term services or subscriptions, customers leaving the business are profit margin killers. Acquiring new customers costs quite a bit more than retaining them, so keeping your customers happy should be a top priority.
Calculating your monthly churn rate, or the percentage of customers that left, for the last several months will help you establish a baseline to work from. For context, high-growth startups hope to keep churn under 1% monthly and 5% for the year.
Once you’ve identified your own monthly churn rate, you can look for ways to bring that number down. Analyze the reasons your customers are leaving and if your company is in a position to address them. You might also consider adding incentives for longer contracts.
Upsell Existing Customers
Your existing customers don’t go through the same sales lifecycle as new customers, meaning that you can likely sell relevant products and services to them much faster than you could bring in someone brand new. So this tip goes hand-in-hand with moving faster.
Look for opportunities to add value to your existing customers. If any of your products or services complement each other nicely, reexamine your sales pitch to see how you might make the combination more appealing. Make a note to also follow up with customers who declined one of them down the road.
Class tracking is an accounting technique that helps you analyze your business by segments. If you own multiple restaurants, for example, you might track their revenue and expenses individually to see how each is performing.
Likewise, if you have multiple product lines, you might want to track the financial performance of each product. Using class tracking, you can analyze which of your products or services has the lowest profit margins. In other words, which ones are bringing down the group average?
When you identify struggling products or services, you can look for ways to improve their margins individually (Fingers crossed it’s as simple as raising the price.) or consider cutting them from your offerings.
Remember the 80/20 rule, which says that roughly 80% of the effects come from 20% of the causes. Chances are high that a small group of your products or services far outperform the rest. It’s worth considering whether doubling down on those more profitable endeavors is a better use of resources.
Introduce New Products
Businesses must constantly evolve to survive in competitive marketplaces. If your profit margins have become slimmer over time, it might be time to try something brand new. Launching a new product or service offering can infuse new life into your business and address your customers’ changing needs.
It’s not a quick-and-easy solution. But new offerings have the potential to pay big dividends if executed well.
For the majority of companies, growth is the ultimate goal, and growth requires testing new ideas, tracking progress, and pivoting as needed. Set a profit margin goal for yourself and test out some of the ideas above to discover what will work for your business.
We’ve got more helpful advice about how to grow your business on the ScaleFactor blog. Ready to speak to an expert about how ScaleFactor can generate reports and useful insights for your business? Schedule a live demo today.