🎉 Tillful is now part of Nav! Learn more about gross profit formula at Nav
Like a human’s pulse rate or blood pressure, certain metrics serve as vital signs for a company’s wellbeing. One of those metrics is profit margin.
Profit margin, or a percentage that tells you a company’s profitability, is considered one of the most important ways to measure a business’ overall financial health.
How do small business owners, new entrepreneurs, and other organizational leaders find meaning in the profit margin metric? Put that percentage into context by learning what a good profit margin is and how to strengthen yours.
What we’ll cover:
- Types of profit margins + how to measure them
- Industry benchmarks for profit margins
- What’s a good profit margin for a new business?
- What’s a good profit margin for an established business?
- How small business owners can get higher profit margins
- FAQ: If I have low margins, should I worry?
Types of profit margins + how to measure them
There are three main types of profit margin, which can be expressed as a percentage or ratio. All go deeper than just earnings by accounting for the cost of goods sold, taxes, and other expenses.
Gross profit margin
Best for: Identifying how profitable a specific offering is
Gross profit margin takes into consideration the cost of goods sold (COGS), which includes items such as raw materials, labor to produce specific products, and factory overhead expenses relating directly to the products.
Many companies use gross margin to determine the profitability of a specific product, not necessarily the business at large. It leaves out certain metrics that can be helpful in determining the financial health of a company. However, comparing your products’ gross margins can show you if there are any expensive outliers in your product line.
Calculate yours with the gross profit margin formula:
Gross profit margin ratio = (revenue – COGS) / revenue
To get a percentage from that solution, simply multiply it by 100.
Operating profit margin
Best for: Identifying how profitable your overall offerings are
Operating profit margin takes it a step further by deducting both COGS and operating expenses (OPEX). Your COGS refers to the cost of your products while OPEX refers to the cost of running your business at large. OPEX may include software subscriptions, general payroll, marketing costs, and more.
While gross profit margin only deducts COGS, operating profit margin deducts both COGS and OPEX. As a result, operating profit margin can give you a better picture of your business’ profit margin across your catalog of offerings, instead of a specific product.
To calculate your operating profit margin ratio:
Operating profit margin ratio = (revenue – cost of goods sold – operating expenses) / revenue
Again, you can get a percentage by multiplying the solution by 100.
Net profit margin
Best for: Identifying your company’s profitability as a whole while considering all business expenses
Net margin deducts the most expenses of any profit margin measurement. In addition to COGS and OPEX, net profit margin subtracts interest and taxes.
Net income is considered a company’s bottom line, so a net profit margin gives you the best picture of your company’s overall profitability.
To calculate your net profit margin ratio:
Net profit margin ratio = (revenue – cost of goods sold – operating expenses – interest – taxes) / revenue
Multiply the solution by 100 to get a percentage.
To recap, how are gross, net, and operating profit margins different from each other? They’re all important for measuring the profitability of your company and its moving parts. However, where gross margin only considers COGS, operating profit margin also considers operating costs, and net profit margin also considers interest and taxes on top of that.
💡Check out this cool calculator that tells you financial ratios like profit margins, liquidity, solvency, and more.
Industry benchmarks for profit margins
A study from the NYU Stern School of Business provides us with average profit margins for a variety of industries.
Fun fact: According to the study, the average net margin for the total market was 9.84%. The average pre-tax, pre-stock compensation operating margin was 13.20% and the average gross margin was 38.44%. In these numbers alone, you can see just how much different types of profit margin vary.
As you look at this table of top industries, consider where your business lies and how your profit margins may compare. Note that startups and small businesses may have different margins than the averages portray, as these numbers are based on financial information from publicly traded companies. We’ll dig more into this below. For now, let’s see where the industry benchmarks get us.
|Industry||Net Margin||Operating Margin||Gross Margin|
|Auto & Truck||3.96%||6.31%||14.25%|
|Business & Consumer Services||4.97%||10.32%||31.80%|
|Environmental & Waste Services||6.72%||13.61%||33.64%|
|Farming & Agriculture||6.03%||7.74%||13.61%|
|Packaging & Container||5.75%||10.21%||21.98%|
The gist: You can’t compare your profit margins to a company in another industry. It just won’t make logical sense! Look at the industry you’re in (if you don’t see your industry on this list, check out the full study here) to get a good idea of where the general industry lies.
What’s a good profit margin for a new business vs. established business?
When you start a new business, there are two ways your profit margins may behave, depending on the industry you’re in and your expenses.
Instance #1: Your profit margins may be lower when your business is new vs. when it’s established.
This is because generating profit can take time. Just look at Tesla, which had its first profitable year in 2021, a full 18 years after its founding. Now, small businesses may feel like they can’t relate to a global and investor-backed company like Tesla, but the concept remains the same. As you grow, so does your revenue and efficiency. If this is the case, give yourself some grace in the early days of business. Your profit margins may be below the industry average until your total sales can catch up.
Makes sense, right? Just wait until you hear about the other scenario that could happen…
Instance #2: Your profit margins may be higher when your business is new vs. when it’s established.
This may occur, for example, if your manufacturing and labor costs increase the more products you sell. If that’s the case, your early days of business may be more like a honeymoon phase rather than squeezed pockets.
This inverse relationship between costs and revenue can put your profit margins above industry averages. This can creep up on you if you’re unprepared. If you’re a new business, look ahead at where your revenue and cost will be if production ramps up. Higher production costs with higher output are possible. That way, you’re ready for reduced profit margins when they come.
How small businesses fit into the picture
Small businesses are often set aside in their own category. In many cases, this makes sense because a small business just doesn’t operate the same as a large conglomerate. However, small business profit margins hover between 5–10%, which falls in line with the average net margin for the total market, 9.84%.
If you’re a small business and your profit margins are reduced, it could be because of additional expenses that small businesses face. For example, you may be paying rent for a brick and mortar location in your town while larger companies operate more digitally than in person. Or you may be hit harder by payment delays, which a big business could more easily swallow.
FAQ: If I have low profit margins, should I worry?
“Financial ratios lead to a deep understanding of your business and allow for industry comparisons. Just remember that industry standards are a reference, not a recipe. There may be strong competitive reasons for you doing something differently.”
— Dr. Patricia G. Greene, 18th Director of the Women’s Bureau, US Department of Labor, former Entrepreneurship Professor
Profit margins are an important weatherwave, but they’re not the be-all-end-all for business success. Operating with a low profit margin can still be okay if you’re doing it strategically. However, there are times when low profit margins are a point of concern. To figure out whether to fret over your profit margins, ask yourself a few key questions:
- Are you seeking capital? The Small Business Administration (SBA) writes, “If you’re looking to raise capital, know that potential investors and lenders will be looking at [profit margin] very closely to assess your company.” Increasing your profit margins can improve your chances of securing capital with reasonable terms.
- Do you want to solidify your longevity in a competitive market? Companies with high profit margin ratios may have a competitive advantage in the market. This could help keep you around longer despite competition.
- Do you want to invest more into your business? Increasing your profit margin can help you do this because it opens up capital for uses other than COGS, OPEX, taxes, and more.
How small business owners can get higher profit margins
If you do decide to actively increase your profit margins, there are ways to go about it. Just remember: Don’t sacrifice the quality of your products or services for the sake of increased margins. Reducing the quality of your offerings could erase any benefits you get from increased margins, which doesn’t do you any good!
Here are a few methods to try to increase your margins:
- Trim business expenses such as operating costs where possible.
- If you utilize raw materials, see if you can source them cheaper.
- Improve cash flow by digging into your outflows and inflows. If you struggle with receiving payments late from customers, consider offering an incentive for early or on-time payment.
- If your costs decrease with increased production, consider ramping up production to increase net sales and total revenue.
- Incorporate automation into your business. Make sure you’re automating the right processes so your business can work as efficiently as possible. This can reduce headcount, lower labor costs, and help you better manage spend.
- Consider changing your pricing strategy. Can you offer a subscription package? How about offering a budget, luxury, or rental option for existing offerings?
Last word on profit margins
Profitability ratios tell you a lot about your business. A healthy profit margin depends on what industry you’re in, but business owners can look to industry benchmarks to get a feel for where their margins ought to be.
Remember: As Greene tells us, financial ratios are a reference, not a recipe. Your business model could operate effectively with lower profit margins, but there are almost always ways to achieve high margins if that’s your goal.