“No business will survive at the end of the day without profit,” warns Bruce Eckfeldt, 5X Inc 500 CEO and strategic business coach. “There are ways to deal with cash flow issues in the short and medium term, if you can show long-term profit.”
While many business owners find the numbers side of running a business tedious or frustrating, they provide insights you can’t get otherwise. Understanding profit margins and building a profitable business is what makes a business successful.
As Eckfeldt explains on his website: “Companies that scale quickly and profitably have established a clearly differentiated position in the market, setting them apart from the competition.”
Types of Profit Margins and How To Calculate Them
A healthy profit margin depends on what industry you’re in. Business owners can look to industry benchmarks to get a feel for where their margins ought to be.
Remember: 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.
In a moment we’ll run through the calculations for various types of profit margins. But let’s first make sure we’re clear about what health profits mean to your business.
Cash Flow Margin vs Profit Margin
Confusing cash flow and profits often trips up small business owners.
“Cash flow is about how money moves through your business,” explains Eckfeldt. “Profit is about what goes in your pocket at the end of the day. Don’t get them confused.
He gives this example from his own business:
“Many/most of our consulting projects had initial payments, but that didn’t cover the cost of hiring and staffing teams and paying salaries while we waited for progress payments,” he says. “We had to model the client progress payments and factor in terms and then see what our payroll schedule was in order to determine if we could “afford” to take on the project.
“We often needed $50,000-100,000 of working capital to finance the project, but in the end, we would end up with $100-200,000 in profit once we collected the final payments.”
In other words, a product or services may be profitable, but if you can’t pay your bills while you wait for all the revenue to come in, your business will be in trouble.
Read: Cash Flow vs Profit: What’s the Difference?
How to Calculate Profit Margins
Here’s how to calculate specific types of profit margins:
Gross Profit Margin
Gross profit margin is a key financial metric that helps you understand the profitability of your products or services.
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. While it doesn’t provide a complete picture of your company’s financial health, 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.
What Is a Good Gross Profit Margin
There’s no one-size-fits-all answer. A good gross profit margin depends on several key factors, including:
- Whether you are supplying physical products or services
- Business size and age
- Industry
To get a benchmark for your industry, refer to the table below, which comes from a study from the NYU Stern School of Business. Other sources for this type of information includes industry trade associations, and accounting professionals who work with clients in those industries.
Use these industry averages as a starting point to evaluate your gross profit margin. If you’re significantly below the average, look for ways to reduce costs or increase prices. If you’re above average, you may have a competitive advantage – consider how to maintain or expand it.
| Industry | Gross Margin |
| Advertising | 26.20% |
| Apparel | 53.04% |
| Auto & Truck | 14.25% |
| Auto Parts | 15.58% |
| Beverage (Alcoholic) | 47.99% |
| Beverage (Soft) | 55.27% |
| Business & Consumer Services | 31.80% |
| Computer Services | 3.42% |
| Education | 47.90% |
| Engineering/Construction | 13.45% |
| Entertainment | 41.94% |
| Environmental & Waste Services | 33.64% |
| Farming & Agriculture | 13.61% |
| Food Wholesalers | 14.85% |
| Grocery Stores | 25.68% |
| Household Products | 50.13% |
| Packaging & Container | 21.98% |
| Real Estate | 47.80% |
| Recreation | 39.32% |
| Restaurant/Dining | 31.52% |
| Retail (General) | 24.32% |
| Retail (Online) | 41.54% |
| Software (Internet) | 61.00% |
| Transportation | 21.25% |
Net Profit Margin
Net profit margin is a crucial metric that shows how much of your revenue translates into actual profit after all expenses are accounted for.
Best for: Identifying your company’s overall profitability while considering all business expenses
Net margin deducts the most expenses of any profit margin measurement. In addition to cost of goods sold (COGS) and operating expenses (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 clearest picture of your company’s overall profitability. This metric helps you understand how efficiently you’re managing your entire business operation.
To calculate your net profit margin ratio:
Net profit margin ratio = (revenue – cost of goods sold – operating expenses – interest – taxes) / revenue
Multiply the result by 100 to get a percentage. A higher percentage indicates better overall profitability for your business.
What Is a Good Net Profit Margin?
As discussed earlier, ‘good’ profit margins depend on many factors, making it difficult to provide a one-size-fits-all benchmark. However, you can use industry averages as a starting point to evaluate your performance.
Here’s a table showing average net profit margins for various industries:
| Industry | Net Margin |
| Advertising | 3.10% |
| Apparel | 7.06% |
| Auto & Truck | 3.96% |
| Auto Parts | 1.34% |
| Beverage (Alcoholic) | 5.07% |
| Beverage (Soft) | 14.47% |
| Business & Consumer Services | 4.97% |
| Computer Services | 27.24% |
| Education | 7.17% |
| Engineering/Construction | 1.81% |
| Entertainment | 3.86% |
| Environmental & Waste Services | 6.72% |
| Farming & Agriculture | 6.03% |
| Food Wholesalers | 0.69% |
| Grocery Stores | 1.11% |
| Household Products | 12.45% |
| Packaging & Container | 5.75% |
| Real Estate | 14.98% |
| Recreation | 4.78% |
| Restaurant/Dining | 12.63% |
| Retail (General) | 2.65% |
| Retail (Online) | 7.26% |
| Software (Internet) | -10.36% |
| Transportation | 5.97% |
Use these industry averages as a starting point to gauge your business’s financial health. If your net profit margin is below average, look for ways to cut costs or increase revenue. If you’re above average, you may have a competitive edge – consider how to maintain or expand it.
Remember, while these averages provide a useful reference, your specific business model, growth stage, and market conditions all play a role in determining what a ‘good’ net profit margin is for your company. Regularly tracking this metric over time can help you identify trends and make informed decisions to improve your overall profitability.
Operating Profit Margin
Operating profit margin is a key metric that shows how much profit your business makes from its core operations, before accounting for interest and taxes.
Best for: Identifying how profitable your overall offerings are
Operating profit margin takes analysis a step further by deducting both cost of goods sold (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’s profit margin across your catalog of offerings, instead of a specific product. This metric helps you understand how efficiently you’re managing your core business operations.
To calculate your operating profit margin ratio:
Operating profit margin ratio = (revenue – cost of goods sold – operating expenses) / revenue
To get a percentage, multiply the result by 100. A higher percentage indicates better operational efficiency and profitability.
For example, if your business has $100,000 in revenue, $60,000 in COGS, and $20,000 in operating expenses:
Operating profit margin = ($100,000 – $60,000 – $20,000) / $100,000 = 0.20 or 20%
This means that for every dollar of revenue, your business keeps 20 cents as operating profit.
Regularly tracking your operating profit margin can help you identify areas for improvement in your business operations and make informed decisions to increase overall profitability.
Contribution Margin
Contribution margin measures how much each product contributes to your overall profit after accounting for variable costs.
Best for: Looking at how a particular product contributes to overall profit
Contribution margin is similar to gross profit margin but focuses specifically on variable costs. You typically use contribution margin when deciding whether to keep a product or how to price it.
While gross profit margin considers all costs of goods sold, contribution margin only looks at variable costs – those that change directly with production volume. This makes it particularly useful for making decisions about individual products or services.
Calculating contribution margin can be challenging because you need accurate variable costs, which can be time-consuming to determine. However, it’s worth the effort, especially if you’re in a competitive industry or making decisions about which products to discontinue.
To calculate your contribution margin:
Contribution margin = revenue – variable costs
You can express this as a dollar amount or as a percentage by dividing the result by revenue and multiplying by 100.
For example, if a product generates $100 in revenue and has $60 in variable costs:
Contribution margin = $100 – $60 = $40 Contribution margin percentage = ($40 / $100) * 100 = 40%
This means the product contributes $40 or 40% of its revenue to cover fixed costs and contribute to profit.
A higher contribution margin indicates that a product is more profitable. By comparing contribution margins across your product line, you can identify which products are most valuable to your business and make informed decisions about pricing, production, and product mix.
EBITDA Margin
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. The EBITDA margin shows how much of your revenue remains after accounting for operating expenses.
Best for: Getting a quick idea of how revenues compare to operating expenses
EBITDA margin is a relatively quick and simple way to gauge a business’s operational profitability. It’s particularly useful for comparing companies within the same industry, regardless of size or capital structure.
However, it’s important to note that EBITDA margin can be misleading since it doesn’t include debt. If your business has significant debt, you may want to focus on other margin metrics that provide a more complete financial picture.
To calculate EBITDA margin:
EBITDA margin = (earnings before interest and tax + amortization + depreciation) / total revenue
Multiply the result by 100 to get a percentage. A higher percentage indicates better operational efficiency.
For example, if a company has:
Earnings before interest and tax: $100,000
Amortization: $10,000
Depreciation: $15,000
Total revenue: $500,000
EBITDA margin = ($100,000 + $10,000 + $15,000) / $500,000 = 0.25 or 25%
This means that 25% of the company’s revenue remains after accounting for operating expenses, before considering interest, taxes, depreciation, and amortization.
EBITDA margin is most useful for:
- Comparing operational efficiency across different companies or industries
- Evaluating businesses with significant depreciation or amortization expenses
- Assessing the potential profitability of a company before financing and tax considerations
Remember, while EBITDA margin provides a quick snapshot of operational efficiency, it shouldn’t be the only metric you use to assess your business’s financial health. Always consider it alongside other financial metrics for a comprehensive view.
How To Choose the Right Profit Margin to Focus On
While all profit margins offer valuable insights, the best one to focus on depends on your specific business needs and goals. Here’s a guide to help you choose:
Gross Profit Margin:
- Focus on this when evaluating individual product profitability
- Use it to make decisions about pricing, product mix, and supplier negotiations
- Ideal for businesses with physical products or when analyzing specific service offerings
Operating Profit Margin:
- Use this to assess your overall operational efficiency
- Helpful when looking to streamline business operations or reduce overhead costs
- Particularly useful for comparing your business to industry benchmarks
Net Profit Margin:
- Focus on this for a comprehensive view of your business’s overall profitability
- Use it when making long-term strategic decisions or when reporting to stakeholders
- Crucial for understanding how much profit you’re actually keeping after all expenses
Contribution Margin:
- Utilize this when deciding which products to keep, discontinue, or promote
- Helpful for break-even analysis and making production volume decisions
- Especially useful in industries with high variable costs and/or lots of SKUs
EBITDA Margin:
- Use this for quick comparisons of operational efficiency, especially across different companies
- Helpful when your business has significant non-cash expenses like depreciation
- Useful when considering potential investments or acquisitions
Tips for effective use of profit margins:
- Don’t rely on just one metric. Although you need to start somewhere (often with gross and net profit margins), keep in mind that each type of profit margin tells a different part of your financial story.
- Track trends over time. Regular monitoring of these margins can reveal important trends in your business performance.
- Compare to industry benchmarks. Understanding how your margins stack up against industry averages can highlight areas for improvement.
- Ensure you’re using good data. The value of these metrics depends entirely on the accuracy of your financial data. If you’re not keeping careful track of your revenue and expenses, it’s going to be hard to find any meaningful insights.
- Align with business goals. Choose the margins that best align with your current business objectives and challenges.
Remember, the goal isn’t just to calculate these margins, but to use them to make informed decisions that improve your business’s financial health and drive growth.
Tools for Tracking and Improving Profit Margins
Earlier, we mentioned that you need up-to-date, clean data to be able to calculate various profit margins. At a minimum, that means you need to:
- Use a business checking account to deposit business revenue. Even if your business collects money from clients in other ways (like Venmo, PayPal or even cash), try to keep revenue flowing through a central business bank account to get a clear picture of total sales.
- Use business credit cards, business charge cards, or business debit cards for business purchases. Avoid commingling business and personal finances.
- Keep your bookkeeping up to date. Many types of accounting software will allow you to run these calculations. Keep your bookkeeping up to date and you or your accounting professional can run this analysis.
Businesses with more sophisticated needs may want to look at advanced software such as:
- ProfitWell: Focused on subscription-based businesses, ProfitWell offers automated financial metrics tracking, including margins. It specializes in optimizing pricing strategies to improve profitability.
- Fathom: A financial analysis and reporting tool that integrates with accounting software to provide in-depth profit margin analysis. It offers customizable KPIs, visual reports, and budgeting features to improve margins.
Bonus: Quick Profit Margin Health Checklist
Here’s a checklist to help you understand and optimize your profit margins:
Calculate Your Margins (as applicable):
□ Gross Profit Margin
□ Operating Profit Margin
□ Net Profit Margin
□ Contribution Margin (for specific products)
□ EBITDA Margin (if applicable)
Compare to Industry Benchmarks:
□ Check your margins against industry averages
□ Identify areas where you’re above or below average
Analyze Costs:
□ Review and trim operating expenses where possible
□ Evaluate raw material costs and seek cheaper alternatives
□ Assess labor costs and efficiency
Improve Cash Flow:
□ Analyze payment terms with customers and suppliers
□ Consider incentives for early or on-time payments
□ Implement efficient invoicing and collection processes
Optimize Production:
□ If applicable, consider increasing production to benefit from economies of scale
□ Evaluate your product mix based on contribution margins
Enhance Efficiency:
□ Identify processes that can be automated
□ Implement appropriate automation to reduce costs and improve accuracy
Review Pricing Strategy:
□ Analyze current pricing structure
□ Consider new pricing models (e.g., subscription, tiered pricing)
□ Explore options for budget, luxury, or rental offerings
Maintain Quality:
□ Ensure cost-cutting measures don’t compromise product/service quality
□ Seek customer feedback on product/service satisfaction
Monitor Trends:
□ Track margin trends over time
□ Identify seasonal patterns or other fluctuations
Take Action:
□ Develop an action plan to address areas of concern
□ Set specific, measurable goals for margin improvement
□ Regularly review and adjust your strategies
□ Consider a business line of credit and/or small business loan to cover expenses when cash flow is tight
Remember: The goal is to improve profitability while providing value to stakeholders, including customers, employees and investors. Neglect them and your business may suffer. Review this data regularly to make sure your business stays financially healthy and competitive.
How Nav Can Help
Nav is here to support small business owners. Nav is the only free financial health platform specifically built for small business owners to track and improve business credit and cash flow health alongside a marketplace of financial products for every stage of growth.
With Nav Prime, small businesses unlock the most comprehensive toolset to build business credit and manage financial health.
FAQ: What’s a Good Profit Margin?
My profit margins are lower than the industry average. Should I be worried?
Maybe, maybe not. It depends on why they are lower than your industry average. If you have a startup, for example, then it’s not uncommon for profit margins to be low. Starting off, many businesses may not hold a lot of negotiating power with key suppliers making their profit margin lower than it will be when the business is stronger and qualifies for better terms.
Likewise, a business that is heavily focused on growth may find expenses exceeding their income due to offering extreme discounts, growing their team significantly, expanding their service offerings, and so on. This can lead to very low or even negative profit margins for a while.
Tip: Learn how to establish business credit to help your business qualify for better payment terms with suppliers.
How often should I calculate my profit margins?
How often you calculate profit margins will depend on your business needs. Not sure? You may want to start with once a quarter and adjust as needed.
Of course, if you have a major change such as a change in suppliers, contracts, products being offered, etc it is a good idea to keep a closer eye on profit margin before, during, and after these changes.
Should I always aim for the highest possible profit margin?
It depends on how you interpret this question. If you interpret the possible as ‘accounting for my unique business, business goals, marketing plan, type of product I’m selling within the industry, target market, etc’ then yes, go for the highest profit margin.
But if you read this as putting profit margin above all else then maybe not.
For example, a salon owner whose target market is clientele that wants a high-end, luxury experience should not be buying the cheapest items possible and renting salon space in an outdated building. That strategy may get them some high profit margins at first, when clients don’t know what type of experience they will have, but it will probably hurt them in the long run when they get bad reviews and clients don’t return.
Similarly, a business that only focuses on higher profit margins and underpays employees probably won’t last a long time.
This article was originally written on August 30, 2024.
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