Running a small business can be a challenge at times. Revenue can fluctuate substantially. Hiring a good crew of employees can be difficult. At the end of the day, if all goes well, your small business turns a profit. Yet, you might be left asking yourself if the profit you made is good compared to other small businesses.
Naturally, this concern makes sense. As a small business owner, you are spending a lot of your time and money on investing in the success of your small business. You want to be sure that your investment is worth it. After all, if the investment stops making sense, you might be tempted to leave to join other ventures or seek other job positions.
To assess this, you will compare the performance of your small business to other small businesses. You would correctly be interested in understanding what a good profit margin means for your small business. This would help you check your profitability against other small businesses as well as allow you a continuous idea of what financial success looks like for your small business. We’ll discuss the following topics in detail in this article:
Reasons to Be Interested in a Good Profit Margin for Your Small Business
One reason you might be interested in understanding what a good profit margin looks like for your small business is so that you can have a convenient way to compare the financial health of your small business to another.
Likewise, financial stakeholders in your small business or its operations will be interested in the financial health of your small business. Lenders for your small business cars or office space will likely be interested in your company’s financials. At the end of the day, they are concerned with your current bottom line or your profit margin, as this indicates to them how much capital is free to pay down lines of credit or provide a financial cushion for your business. While the exact metrics a lender requests will depend on the situation, comparing your business’ profit margin to a peer or industry standard is a likely next step in acquiring financial support for your small business.
Vendors might also be interested in the profit margin of your small business. Depending on the market that your small business operates in, the profit margin of your small business may be very important. If you are signing contracts with vendors for a certain amount of time, your vendors might expect a degree of stability from your small business. One of the ways that vendors can understand the financial health and stability of your small business is through its profit margin.
What a Profit Margin Means
There are two ways to efficiently understand what a profit margin is. There is a general explanation and a technical explanation. Both are important ways to understand the meaning and calculation of a business’s profit margin.
A Profit Margin, Put Simply
Simply, a profit margin is the percentage of money that your small business retains as profit against the money that your small business takes in as revenue. Essentially, this is the percentage of money that your business is left with at the end of the day against the portion of the money that they take in at the beginning of the day.
A Profit Margin, Put Technically
The second explanation of profit margin is more technical and helpful to understand so that you can calculate profit. Most of this information can be seen on the income statement for a small business. It might be helpful to look at it while following along to understand your cash flow.
To get to a profit margin, you need to start with revenue. Revenue, otherwise known as net sales or total sales, is the money generated by a small business for all of its business activities. It is the recorded number for any inbound money to the small business.
After revenue is the cost of goods sold. Cost of goods sold, sometimes referred to as cogs, is a metric measuring the direct costs, or production costs, of producing your good or service for selling. After factoring in your costs of goods sold, you get a gross profit margin. This gross profit margin is the percentage of gross profit against revenue. Essentially, this is the amount of money left over to pay general business expenses, taxes, and interest and then potentially have money left over for profit.
Next comes your operating expenses. Your operating expenses can be many things. Most likely, your small business will have SG&A costs or sales, general, and administrative costs. In this, a lot of marketing, sales, and general employee costs might be wrapped up in it. This contains a lot of the day-to-day overhead expenses that a small business would face. Alongside other expenses, you will eventually reach operating income.
Operating income, or operating profit, is a measure of the profit your small business has after you subtract expenses related to the operation of your company. From finding out your operating profit, you can then calculate your operating profit margin. Your operating profit margin is your operating profit measured as a percentage of your revenues.
Your operating profit margin reflects your operating costs and your overhead costs. Financial statements will provide more detail as to the allocation of what is exactly contained in these costs, such as labor costs or depreciation, but your operating profit margin provides valuable information in understanding how efficiently your business is being managed.
After your operating margin is the work toward understanding the overall profitability of the business. After subtracting out the taxes and interest the business owes, you have finally subtracted out the total expenses of your small business. You have now arrived at a number called net income.
Net income is the profit that leads to the net profit margin, commonly referred to when comparing the profit margin of a small business. The net profit margin is net income as a percentage compared against total revenue.
While this technical explanation has a lot of bookkeeping terminology, it is critical to understand the deep dive into an income statement and understand the different types of profit margins to be able to distinguish between a business’s profit margin and other types of margins. The net profit margin allows for an accurate measurement of the company’s profit in comparison to its revenue.
It is also necessary to understand the general dynamics of profit margin consideration. A low profit margin is bad. A low profit margin means that a small business is unable to turn a considerable level of profit on every dollar it takes in. Over time, this could mean that the small business is running inefficiently or is unable to sell its good or services at an adequate price. This could indicate a problem with the pricing strategy, for example. Lower profit margins are bad, of course, but they might be considered to be more normal in a new business trying to get off the ground. They might be experiencing understandable challenges. Thus, a lower profit margin might not be a wholly negative sign.
A healthy profit margin for your small business depends on many things, including the different industries your small business might be in. Your business might excel with a high profit margin, or it might be considered to excel against businesses in an industry with lower profit margins.
Over time you will want to consider your average profit margin since your profit margin will fluctuate. Higher profit margins might only be temporary over a short period, so considering your profit margins in the long term is the best way to gauge your small business’s financial performance.
Contextualizing a Good Profit Margin for a Small Business
While a good profit margin for a small business varies by industry, it may be useful to contextualize your profit margin against general ideas of a good profit margin. A margin of 5% is generally not that high. While you might not be receiving negative profits, 5% does not leave a lot of room for error.
A 10% profit margin is largely regarded as a standard for a small business profit margin. If your small business is achieving a 10% profit margin, you are doing alright. A 15-20% profit margin indicates a really strong business with a good profit margin. Broadly speaking, a 15-20% profit margin for your small business could be exactly what you are aiming for.
A good profit margin does not just signify a good business in terms of how well it runs its operations or how it is doing compared to its competitors. It also offers a frame of reference for how your business can handle adverse situations.
For example, if your small business is working with a profit margin of 5% or less, your small business may not be well equipped to handle unexpected expenses. Since the room for error is so small with this profit margin, if a serious cost is levied against your business, you may not be able to pay it that easily. If you do, your profit margin may have seriously decreased. You may also dip into negative profits.
A profit margin of 10% seems to allow more flexibility. If there is an unexpected change in the costs of one of your product inputs or you are affected by a lawsuit, for example, your cash flow may be able to help support the expense. Moreover, this may prevent you from being pushed into negative profit.
A profit margin of 15% or larger is a great sign. It shows that the business can efficiently capture profits from the products or services that it sells. It leaves your small business with enough of a margin to invest in the future growth and development of the company. It is also a positive sign to investors if you try to raise capital in the future if your business has a good profit margin.
While you may have the largest stake in the small business as the small business owner, your profit margin will be important for many people. Stakeholders in your business will be interested in its financial health and long-term feasibility. That is why it is important to maintain a good profit margin for your small business, so investors and creditors alike can be confident in the operations of your business.
Comparing Your Profit Margin with Others
While there are some general guidelines about what makes a good profit margin, it is important to remember that the best and most accurate comparisons will depend on looking at comparable businesses in other industries.
Part of the reason for this is that different industries have different cost structures for operating their business. While financial services tend to have higher margins since they do not have fixed costs, businesses in the manufacturing industry might have lower margins with high fixed costs from raw materials. These margins might be altogether different from a grocery store’s profit margin. While you might have a restaurant, the margins might be slightly smaller relative to a plumbing business. Whereas bakeries have high labor costs and some expenses when it comes to food that is not sold before it expires, plumbers can control their costs a little bit more.
Plumbers might have an accurate idea of how much a given project will cost, both in terms of materials and labor hours. Once they have this picture, they can accurately quote a project, leaving a lot of room for margin. This is enhanced by the fact that there is sometimes a shortage of plumbers. This allows plumbers to increase their margins. Since this does not necessarily reflect the price of their inputs, their margins might be better than a restaurant.
Does that mean that the bakery has a bad profit margin? Not at all. What it does mean is that these two businesses are operating in different industries, which is normal. Instead of comparing your restaurant with a local plumbing business, you should try to compare your restaurant with other restaurants in the area.
Comparing your small business restaurants with other restaurants in your area will likely be difficult. This is because the financials of these businesses are usually hidden from the public. The private ownership of restaurants may prevent you from looking at their financial statements, especially as a competitor.
You might, however, be able to find industry-standard information available. NYU has an up-to-date collection of profit margins by industry in America. Some of the most common profit margins for small businesses are listed below:
- Advertising – 3.79%
- Apparel – 5.07%
- Auto Parts – 2.16%
- Beverage (Alcoholic) – 5.76%
- Computer Services – 2.53%
- Construction Supplies – 8.23%
- Environmental & Waste Services – 7.29%
- Farming/Agriculture – 5.66%
- Financial svcs. (Non-bank & Insurance) – 26.32%
- Homebuilding – 13.98%
- Restaurant/Dining – 9.28%
- Retail (General) – 2.35%
- Trucking – 1.29%
- Total Market – 8.89%
As you can see, the profit margins vary quite substantially. This is normal. It is important to remember that while profit margin reflects how efficiently you make a profit on every dollar of sales, it does not reflect the overall profit your make. You can make a lot of profit through a sheer volume of sales, even if your profit margin is not high.
Yet, there is still ample reason to be sure that you are comparing your profit margin to peers in your industry. You want to be sure that your cost structure is running efficiently. The best way to do this is to see how your costs are compared to small businesses like yours.
To choose small businesses to compare with, you should also consider where these small are located. While it might be harder to find granular data on the margins of small businesses in different locations throughout the United States, it is still relevant to consider the cost differences.
For example, your small business might be located in New York City or Miami. Both of these cities will have high rent costs for the physical location of your small business. In addition, the input costs for your small business might be higher. Getting the supplies to your location cost more than other locations. Labor will likely also be more expensive than in places not in cities with high rent. An example of this would be Cheyenne, Wyoming. If your small business was located in Cheyenne, you would likely have lower rent, labor costs per hour, and overall lower input costs.
Considering this context is important. For a business in an identical industry with an identical profile, you would expect the business located in Cheyenne to have a higher profit margin than one in New York City or Miami.
When is a Profit Margin Good?
Another relevant question to determining a good profit margin for your small business is to consider when that profit margin is good. As with businesses in different industries, as well as businesses in different locations, a good profit margin will depend also on the age of the business.
Generally, profit margins may be low in the very early stages of your small business or startup. This is because you may not have enough recognition in the community for people to know about your business. It could also be because your product is not finished, and you need to still develop it. In any case, you can see that there might be reasons for a lower profit margin at the start of the business.
Once your business matures, you might expect your profit margin to increase. Indeed, this would be a reasonable expectation. Your profit margin could increase after the initial stage of your business and be able to facilitate healthy growth. This is potential because your small business might be able to harness increasing returns to scale.
As your small business reaches the later stages of its existence, you might be experiencing decreasing returns to scale. If this is the case, your profit margin might slump slightly. There may be a rational context for this.
While each financial situation is different for each business, it might be important for you to consider the financial story of your business development. You can help contextualize your profit margin against others’ partly by identifying the stage your small business is at. It might help you understand the need to drive your profit margin higher at the early stages of your small business or make you feel more confident in your current position. In any case, it is important to consider a reasonably good profit margin for the relevant stage of your small business.
How to Increase Your Profit Margin
While your profit margin for your small business may not be perfect, there are options to improve it. There are many ways to increase your profit margin.
Lower Your Costs
One of the ways to increase your profit margin is to lower your costs. Your costs can be concentrated in many areas, including the rent for your small business, the materials you use to produce your goods or services, and labor.
While labor is harder to negotiate down once you have employees working for you and is potentially controversial, it might be worth it to consider negotiating your other expenses. Speaking with your landlord about lowering your rent might get your rent lowered. Your rent may be a seriously large expenditure for your small business. Getting that expense lowered could greatly improve your profit margin.
Another area to target expense reduction would be to negotiate with suppliers on your pricing. Whether your inputs are food, raw materials, or tools, you might be able to negotiate a lower price with your suppliers. If you do so, you can lower your cost of goods sold, increasing your profit margin.
While decreasing costs will improve your profit margin by making your cost structure more efficient, increasing prices is also an option to increase your profit margin by taking in more money. By increasing prices, you are theoretically still selling the same amount of goods or services. That same number of goods or services sold just brings in more money in the form of increased prices.
To increase prices, you should be cautious about the effects of increased prices on demand. While keeping this in mind, you can see how feasible your price increases will be based on your target profit margin. This is because you can set a target profit margin and calculate backward to determine just how much revenue your current costs would require. You can then take that change and determine if that change would be a reasonable price increase for your business.
Profit margins are something every small business should watch carefully and take seriously. Even small changes in your margins can have a significant impact at scale. Just a 5% increase in your margins when you are doing, for example, $300,000 of revenue a year can mean an increase in profit of $15,000. This isn’t something to sneeze at.
However, in order to actually manage your profit margins, you have to understand them and know what a good profit margin is for your industry. It can help to research profit margins for your industry before even starting your business and include the results in your business plan so that you have a clear benchmark for what you would like to achieve. Also, consider competitors and try to figure out what sorts of margins they are operating with. It can be very difficult to compete with your competition if they are running significantly higher margins than you – and if you are able to run higher margins than them, it can give your business a huge leg up.
As with anything, diligence is key. Staying on top of your margins and keeping careful track of changes over time is critical. This can seem like a lot of work, but with the right approach and the proper care, it can make a world of difference for your business in both the short term and, even more importantly, in the long term.
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