Profit margin is one of the most important financial metrics for business and finance leaders at SMBs
It represents the percentage of revenue that remains as profit after accounting for expenses and helps business owners and financial professionals understand the overall health of the organization.
In this guide, we’ll dive deep into what profit margin is, the different types of profit margins that exist, how to calculate it, and actionable ways to improve your own margin for a healthier bottom line.
What is profit margin?
Definition of profit margin
Profit margin (sometimes referred to as profit margin ratio) is a financial metric that measures how much of a company's revenue turns into profit after covering expenses.
It's expressed as a percentage of revenue. For example, if you earn $100 and spend $60 on expenses, you have $40 left as profit, and your profit margin would be 40%.
The formula for profit margin is:
By analyzing profit margins, businesses can determine whether they are pricing their products or services effectively, managing costs efficiently, and maintaining sustainable operations.
Types of profit margin
There are three main kinds of profit margin
- Gross profit margin
- Operating profit margin
- Net profit margin
Let’s explore each in greater detail.
1. Gross profit margin
Gross profit margin is a measure of how much profit a business makes after deducting its cost of goods sold (COGS), expressed as a percentage of revenue. It's useful as an indicator of production efficiency and pricing strategy.
The formula for gross profit margin is:
Higher gross profit margins suggest that a business is generating strong profits from its core offer before considering overhead costs like rent.
2. Operating profit margin
Operating profit margin is like gross profit margin, but it also accounts for operating expenses such as rent, salaries, and marketing costs. It still excludes non-operating expenses such as taxes and interest.
The formula for operating profit margin is:
This metric measures how efficiently a company manages its operations as a whole, beyond just production costs.
3. Net profit margin
The final profit margin, net profit margin, is the most comprehensive measure of profitability. It considers all expenses, including taxes, depreciation, amortization, and interest.
The formula for net profit margin is:
This metric reflects the company’s bottom line and provides insight into its ability to generate actual profit after all costs are considered.
Of all three profit margins, this is the most useful in assessing how profitable a company is.
Importance of profit margin
Profit margin plays a vital role in business success.
It helps business and finance leaders:
- Assess financial health: A strong profit margin indicates a financially stable business, while a declining margin may signal rising costs or ineffective pricing.
- Make smarter decisions: Profit margin helps business owners make informed choices about cost control, pricing strategies, and investments.
- Create informed pricing strategies: A well-balanced margin ensures competitive pricing without sacrificing profitability. Understanding margins helps SMBs price products or services sustainably.
How to determine profit margin
Calculating profit margin is a fairly straightforward affair, though the formula you’ll use depends on the type of profit margin you wish to calculate.
Let’s walk through an example using all three kinds of profit margin discussed above.
Imagine a business generates $50,000 in revenue. Its COGS total $20,000, its operating expenses amount to $10,000, and its taxes and interest for the period are $5,000.
Here’s what its profit margin figures would look like:
- Gross profit margin: (($50,000 - $20,000) / $50,000) x 100 = 60%
- Operating profit margin: (($50,000 - $30,000) / $50,000) x 100 = 40%
- Net profit margin: (($50,000 - $35,000) / $50,000) x 100 = 30%
As you can see, understanding what the different profit margins communicate is critical.
While the business turns 60% of its revenue into gross profit, only 30% is left over as cash after accounting for all operating and non-operating expenses.
What constitutes a good profit margin?
Once you’ve calculated your own profit margin, the next question is only natural:
So, is this a good profit margin?
The truth is that there is no universal “good” profit margin. It varies a lot by industry and even significantly by companies within an industry.
Some businesses operate with high margins but low sales volume (e.g., luxury goods), while others have lower margins but high turnover (e.g., grocery stores).
To give you an idea, higher-volume retail businesses tend to have net margins of between 2% and 5%. This might not seem like a lot, but they’re doing so much volume that the actual profit in dollar terms is still high.
Software companies, on the other hand, might have net profit margins exceeding 20% but much lower total revenue.
Factors such as pricing power, competition, operational efficiency, and even your business model can all heavily impact margin expectations.
For instance, a high-quality leather shoe retailer might aim for a profit margin of 25%, while a lower-priced alternative might be happy with something closer to 5%. Even though they occupy the same industry, the companies’ margin expectations are informed by their differing business models.
For this reason, it’s important to understand the balance of volume and margin, as businesses with low margins can still be highly profitable if they’re able to scale effectively.
Ways to improve your profit margin
Now that you’ve got a stronger understanding of what profit margin is and the various factors that can affect it, you’re probably wondering how to improve your own margin.
Here are a few effective and practical strategies you can implement today to improve your profit margin.
1. Look for opportunities to reduce costs (without sacrificing quality)
Lowering costs is an effective way to increase your profit margin, but you’ll want to be careful to do so in a manner that doesn’t impact product or service quality.
Some ideas here include:
- Renegotiating existing supplier contracts to secure a better rate
- Streamlining operations with workflow automation
- Reducing unnecessary expenditure that isn’t growth-focused
2. Increase sales (without raising costs)
The other major strategy for improving your profit margin is to increase sales revenue. However, you need to be careful not to increase costs at the same time.
Here are a couple of ways you influence additional revenue:
- Work on improving marketing targeting to attract higher-value customers
- Upsell and cross-sell to existing customers
3. Enhance product value and pricing
The last way you can influence a stronger profit margin is to increase your pricing.
Of course, simply putting up your price likely isn’t enough, and you run the risk of no longer being competitive in your market.
However, there are a few ways you can do this effectively, including the following:
- Differentiating your offerings to justify higher prices (such as implementing a premium positioning approach)
- Package products/services in ways that increase perceived value
- Adjust pricing based on demand and competitive positioning
Track profit margin in real time
Profit margin is a key indicator of business success. As a core metric, it helps business leaders understand financial performance, make strategic decisions, and optimize operations.
Whether through cost management, pricing adjustments, or efficiency improvements, increasing the profit margin can lead to greater profitability and business growth.
Of course, you’ll need to track the effectiveness of these changes, for which you’ll want an effective financial reporting solution.
BILL’s integrated financial operations platform offers a wide-range of solutions for tracking and improving profit margin, including:
