As a business owner, it’s important to know how much money your business is making. Having a profitable business is beneficial to your operations and is crucial when looking for investors or any other funding. To find out if your business is profitable, you’ll need to know your profit margin which can be calculated through regularly running a profit market analysis. In this article, we’ll cover:
- What a profit margin analysis is
- Understanding profit margins
- Types of profit margins
- How to conduct a profit margin analysis
What is a profit margin analysis?
A profit margin analysis is a view of your business’ profitability over time. A profit margin analysis is usually performed over a longer period of time like five years, but some companies choose to do them more or less frequently. This data allows you to compare your business to your competitors, and your overall industry, to see how well your business is really doing.
What is a profit margin?
Your profit margin is a comparison of your business’ net income, or gross income minus expenses, to your revenue and shows the degree to which your business is making money. This means that your profit margin reflects how well you use your earnings to pay for business expenses. Many factors affect your business expenses like number of employees, inventory management and even your location.
Profit margins are a better indicator of your business’ financial health, management’s skill, and growth potential than dollar amounts of gross sales, business expenses and earnings.
Every industry has a unique average profit margin, so when you calculate your own, make sure you’re only comparing numbers with your own industry. Narrowing that average down to businesses with similar revenue or business just in your area will give you a better idea of how your business is doing.
Types of profit margins
Profit margins are split into distinct levels, with each level dependent on the one before. They are:
- Gross profit: what’s left after paying for the costs of products or services
- Operating profit: what’s left after paying for operating costs
- Net profit: what’s left after paying for debts and taxes
Let’s take a deeper look into each of these.
Gross profit margin
Your gross profit margin shows you how much profit you’ve made on your cost of goods sold (COGS) and can tell you how efficiently you use labor and supplies in the production process. Gross profit is usually conducted on a per-product basis, and the aggregate is used in calculations for your business’ overall profits.
Gross profit margin is found using this formula:
Gross Profit Margin = (Sales – COGS) / Sales
Changes in sales prices, number of products sold and product mix can increase or decrease your gross profit margin.
Operating profit margin
Your operating profit margin tells you how well your business operations are running. Also referred to as earning before interest and taxes (EBIT), your operating profit margin subtracts operating expenses from gross profit margin and is used to value businesses during potential buyouts. Operating expenses include rent, equipment, marketing, payroll, etc.
Operating profit margin is found using this formula:
Operating Profit Margin = EBIT / Sales
Net profit margin
Your net profit margin shows what percentage of your sales you are using to pay for all of your business’ expenses. This is the number people usually are referring to when they ask for a company’s profit margin. Net profit differs from operating profit in that it includes taxes and debts.
Net profit margin is found using this formula:
Net Profit Margin = Net Profit / Sales
How to do a profit margin analysis
To conduct a profit margin analysis, follow these steps:
Use the formulas above to calculate your gross, operating, and net profit margins for any specific time period.
- Research your competitors’ profit margins by answering these questions:
- What is their gross profit margin? Operating profit margin? Net profit margin?
- Have their margins changed over time? (e.g., increased or decreased)
- Compare your profit margins to your competitors’.
- Use your findings to improve your profit margin by avoiding the mistakes your competitors’ have made over time.
While larger, more seasoned businesses with well organized books can conduct their profit margin analysis more easily, start-ups and small businesses should seek out experts to make sure their calculations are done correctly. Contact our professionals at Lodestar today to see how we can help you and your business understand your profit margins and ways to improve them.