3 Ways Small Business Owners Can Use Profit Margin to Guide Their Business

October 10, 2022
Business Basics

Selling profitable products and services often feels like a moving target. You're attempting to price what you're selling accurately, but as your business grows, things simply change! Your costs increase, introducing new products, and removing non-performing services over time.

How do you measure your earnings from your products and services?

Profit margin!

The average profit margin for a company is around 10%. Your small business could be outperforming this benchmark or missing it entirely. The only way to know for sure is to understand what a profit margin is and how it's calculated.

We'll explain that to you in the article below while highlighting some strategies your business can use to improve its profit margins and growth.

Let's get started.

What is Profit Margin? How Do You Calculate It?

Profit margin is one way for a small business to figure out how much money it's earning on a per-sale basis. More specifically, it measures the number of cents a company earns for each dollar in sales it achieves.

Your business may find value in using several different kinds of profit margins. Here's how to calculate each of them.

Net Profit Margin

Net profit margin = (Revenue – Cost) / Revenue

This is the primary measurement that most people think of when they hear the word profit margin. It gives you an overall measure of how much your business earns for every dollar of sales.

Gross Profit Margin

Gross profit margin = (Net sales - Cost of Goods Sold) / Net Sales

This metric begins with a company's net sales figure and subtracts the direct cost incurred to produce the products sold, such as labor and materials.

The measurement helps identify how different products in your suite compare to one another on a profitability basis. But it doesn't give you your most accurate profitability measurement for the business overall.

Operating Profit Margin

Operating Profit Margin = (Operating Income / Revenue) x 100

This formula will reveal your company's earnings before interest and taxes (EBIT). It's typically used as a measurement for financial investors and analysts to determine a business's value in a potential buyout.

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How to Use Profit Margins to Grow Your Business

You can leverage the information you gain from calculating your profit margins to grow your business. Here are three of the most practical examples for your small business.

1. Track Everything

You have to track information about your sales performance, cost of materials, labor charges, and more to calculate your profit margins. The more data your business has, the more informed its decisions can be.

That means consistently measuring your profit margins will help you stay on top of all the other vital measurements relevant to your company's success. Armed with this information, you can make smarter decisions about adjusting your company's operations moving forward to promote growth.

2. Discover New Avenues for Profitability

Calculating your profit margins will also help you identify your most significant opportunities for improvement.

For example, if you try calculating the gross profit margin of a product, you might realize that you're spending an excessive amount on materials to create it. This could lead to you seeking new materials or a new provider that can cut costs and improve margins.

Many small business owners assume the only way to increase profits is to raise prices. But when you calculate the profit margin, you'll quickly see this isn't the case. Lowering the cost to produce a product or service allows you to increase your profits as well.

3. Identify Successes and Failures Faster

Comparing the profit margins of different products can also help you quickly identify your successes and failures. This is because your profit margin calculation will immediately tell you where certain products are poor sellers, cost too much to create, or have some other flaw.

When you can determine whether a product is a success or a failure faster, you can cut your losses immediately so that your winners are always prioritized.

Strategies for Increasing Your Profit Margins

Now that we know what profit margins are, how to calculate them, and how to use them to grow your company, let's look at some strategies for increasing yours.

Outsource Where it Makes Sense

Outsourcing can save a company a lot of money in production and labor costs. In the past, this was only really an option for larger businesses. But now, practically any business can outsource its customer support and manufacturing processes to a country where they may be more affordable.

If you can bring down these costs, then your profit margins will go up even if you don't raise the price of your products.

Focus on SEO Marketing

You need marketing to get the word out about your products. But things like TV ads, pay-per-click ads, and partnerships with social media influencers can be expensive and decrease your margins.

That's why it could make sense for your business to begin focusing on SEO marketing.

With SEO marketing, you can create evergreen content that ranks at the top of Google whenever a potential customer types in a phrase relevant to your products.

If you do this well, your company will get free advertising for every keyword it ranks for. That can save you a ton on marketing costs over the long run, ultimately lowering your business's overall costs.

Prioritize Products with the Highest Margins

It also typically makes sense for a business to prioritize products that earn the most significant margins. Once you start calculating your margins for each product or service you sell, it will become immediately apparent which ones are winners versus underperforming.

Once you've determined, your advertising budget and sales goals should focus on the products and services that earn you the most per dollar of revenue. Doing that should increase the overall profitability of your company.

Search for New Revenue Streams

You can also use the formulas for calculating profit margins to make more informed decisions about new potential revenue streams.

For example, you might be considering launching a new sweater collection if you run an online boutique. Suppose you know what the profit margins are for your other products. In that case, you can quickly evaluate whether that sweater collection is worth investing your time and money in or if you're better off looking for an alternative.

Using profit margins in this kind of proactive way can be helpful for strategic planning so that you can gradually bring the highest profit margins to your business possible.

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Kellan Jansen
Written by:
Kellan Jansen

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