Profit margin and net profit are two very important metrics for any business (small businesses especially). If you want to make a lot of money in your small business, it is absolutely crucial that you know how to calculate both. This article will teach you the basics of how to do this calculation and how it can help your small business grow.
So what exactly is the profit margin? Well, I’m glad you asked!
What Is Profit Margin?
Profit margin is pretty much what it sounds like: it measures the profitability of a product or service. It also measures the potential earnings and financial health of a business. It does this by taking the amount of money that was made from selling something and dividing it by the total amount spent to sell the said thing. For example: if an item costs $5 to make and you sold it for $15, then your profit margin is 300%.
This sounds easy enough, but business owners are often stumped with these questions: How exactly does this help me run my small business? Won’t I just be losing money if I still sell items that aren’t profitable? Why bother calculating it in the first place?
Well, like most problems with running a business (or life in general), there is no one size fits all answer. But generally speaking, knowing your product’s or service’s profit margin can help you plan effectively for the future of your company. For example: maybe you find out that your product has an abysmal profit margin of 50%. This means that every time you sell an item, only half of the total cost of the item is actually going into your pocket. You could either lower the price or try to increase sales volume, but you need to know this information in order to make a proper plan for your business’s future growth.
How Do I Calculate Profit Margin?
Now that we’ve defined what a profit margin is, let’s get down to how it can be calculated! While there are several methods of doing this calculation, the most commonly used one is called “margin of gross profit.” Here is how it works.
Step 1: Find Cost Of Goods Sold (COGS)
This step just involves finding all of your expenses related to producing and selling an individual good or service. For example: if you sell a service, then your COGS would be the amount of money you had to pay your employees, subcontractors, etc. in order to get that service completed. If you sell a physical product, then your COGS would be how much it cost you to produce that product (how many man-hours or machines are needed are just some examples).
Step 2: Find Gross Margin
To find gross margin, subtract your COGS from your total revenue.
If you sold an item for $100 and had a COGS of $20, then you’d have a gross profit margin of 80%.
Simple right? Now let’s move on to net profit!
What Is Net Profit?
Net profit is the actual amount of money that is left over after factoring in all of your expenses. If you take your revenue and subtract it by all of your expenses, the amount left over is the net profit. Now, this may not sound like much information, but knowing how to calculate net profit can be very crucial for motivating business owners.
Why Is It Crucial That I Know How To Calculate Net Profit?
Net profit is just another way of looking at how profitable a specific product or service is. So while gross margin takes into account only direct costs (materials used), net profit considers more things that contribute to company growth. This means that if you find out that an individual product has a low gross margin, then you might have to look somewhere else to cut costs. Whereas if you find out that an individual product has low net profit, it may mean that you’re just not selling enough of the product to make more money. This way, you can see if there’s another product or service that you should be focusing on instead of constantly trying to improve this one.
So while we recommend knowing how to calculate your gross profit margin for each individual item your business sells, we also want to remind you that these calculations aren’t necessarily the end all be all. Just because a specific product has a high-profit margin and is highly profitable, doesn’t necessarily mean that it makes sense for you to keep carrying it. For example: maybe you find out that only 20% of the customers who buy your book about weight loss go on to buy the cookbook that you sell in your store. This could mean two things: 1) weight loss books aren’t selling well; or 2) people who buy weight loss books aren’t interested in buying any other products or services, therefore it makes no sense for you to carry a cookbook (even though you’d make more money overall if you did).
Whatever kind of calculation method works best for your business, just remember that knowing how much profit you’re making is crucial. And once you do know this information, don’t be afraid to conduct further research into finding out if there are additional ways that your company can improve its bottom line!