Formula for Profit Margin
You can look at several metrics to understand whether your business is profitable—that is, whether you’re bringing in more money than you’re paying out. Some examples of profit metrics include return on assets, total profit, and profit margin.
In this guide, you’ll learn more about profit margin, including why it matters, how to calculate it, and how you might improve it for your products or business.
What Is Profit Margin and Why Does It Matter?
Profit margin refers to the difference between your sales revenue and the costs related to generating that revenue. It is typically expressed as a percentage.
For example, if you make $10 on a widget that costs $8 to build and sell, your profit is $2. Your profit margin is 20%.
Understanding your profit margin is essential because this metric is a good measure of whether your company or business line is fiscally healthy. Using a percentage instead of a dollar amount also takes certain factors out of the equation to help you compare that fiscal health to industry standards, competitors, or other products within your own business.
That allows you to make better decisions about financial goals and what investments to make within your company.
What Is the Profit Margin Formula?
The profit margin formula is the mathematical formula that lets you calculate this metric. The formula is:
(Revenue – Cost)/Revenue
Let’s dig a bit more into how this formula plays out with a hypothetical example: a business that creates online marketing copy for clients.
Discover All Costs Per Sale
In this hypothetical example, the business must first understand all the costs of creating and delivering the product to the client. Imagine that the business provides a 1,000-word landing page to the client. It records all the expenses related directly to that product:
- $50 worth of labor costs/hours for SEO and keyword research
- $70 paid to a writer to create the copy
- $20 paid to an editor to proof the copy
- $15 worth of administrative costs/hours to finalize and deliver the copy
The total cost to the business for this product is $155.
Discover All Revenue Per Sale
To calculate profit margin, the business must also know how much it made on the product. In this example, it’s pretty straightforward: it’s the amount charged to the client for the 1,000-word landing page. Let’s say the client paid $300 for the page.
Calculate Profit Margin
The profit margin is calculated by:
- (Revenue – Cost)/revenue
- (300-155)/300
- 145/300
- 0.48
Multiply the final answer by 100 to convert it into a percent, and you see that the profit margin here is 48%.
Per-Sale Profit Margin vs. Overall Profit Margin
You can calculate profit margin per sale, per product or line of business, or for an entire company. Changing the scale of your profit margin calculations provides you with different information about your business:
- Profit margin for a specific sale or product. Remaining aware of your profit margin for each sale can be crucial. It lets you know how to price products and services and provides some information about how much wiggle room you have to negotiate with customers, if applicable.
- Profit margin per sector, product line, or department. Reviewing and comparing profit margins for different areas of your business can help you understand what sectors are performing and which may need more work. It can also help you know whether a particular product line is viable compared to the rest of your business. Suppose all your products are performing at profit margins of 10% and one is performing at 2%, for example. In that case, you may want to consider whether there are any other business reasons to keep that lower-performing product. If not, you may find more overall profit by closing it.
- Total profit margin. Your total profit margin is the number for your entire business. This margin can be more complicated to calculate, as you’ll need to spend time gathering a lot of information about costs. However, once you know this number, you know whether your business is making money and how much. If your total profit margin is pretty high, for example, you have a lot of profit to play with, and it might be a good time to invest profits back into your business and seek growth. If profit margins are very low, you may be in a lean time and need to find ways to cut costs to create more fiscal health for your company.
Tips for Improving Profit Margin
Obviously, there are two main things you can do to improve profit margins. You can cut costs or increase revenue. But within those two categories, there are lots of steps you can take. We’ve summarized some options below to help you improve profit margins per product line or for your overall business.
Increase Value So You Can Increase Prices
You may be able to increase prices slightly without customers complaining or finding another place to get their goods and services. Consumers do understand inflation and other economic factors and that prices may go up over time. However, if you can increase the perceived value for consumers, you’ll have more luck with a price hike. Some ways to do this include:
- Improving the overall perception of your brand
- Ensuring quality is always top-notch
- Providing education for consumers about why your products are better
Create Efficiencies to Save on Labor Costs
Streamline workflows and cut out unnecessary steps to reduce labor costs. Encourage teams to increase productivity by offering incentives and otherwise rewarding efficiency. If you can shave off just a few minutes per product or cut down on time-to-market for major dev projects, you can substantially increase profit margins.
Renegotiate With Supplies to Cut Inventory Costs
Look at how much you pay for raw materials and other supplies. Cutting down on these costs automatically increase profit margin, so shop around and get quotes from other suppliers. Negotiate with current supplies for reduced prices if you place bulk orders. You might also look at your invoicing processes; if you can get a discount by paying invoices early, that savings boosts your profit margin.
Improve Quality Processes to Reduce Errors
Errors lead to rework, including remaking products, repulling orders, or refunding and replacing items. All of these errors add to cost and bring down your profit margin. Look for ways to build quality checks into every process to reduce errors—without adding a great deal of labor time and expense.
Encourage Ways to Increase Order Values
Increasing order values boosts revenue per order without an equal boost to expense. If someone is already working on or shipping an order, adding another item into the mix doesn’t take as much extra work as an entire new order does. Find ways to encourage customers to add on to orders to benefit from this cost savings.
Profit Margins: One Part of the Fiscal Pie
Remember that profit margins, while important, are only one part of the picture of your company’s financial health. It’s essential to keep an eye on your balance sheets, cash flow, and overall revenue growth too. Use the profit margin formula regularly to understand whether specific products, business lines, or your company as a whole are making money, but ensure you’re engaging in overall healthy accounting practices as well.
By Darryl Sykes CEO of Synture.com
