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As a small business owner, you probably know what profit is, and what you would consider a good profit. But what exactly is net profit margin? And what is a good margin?
Simply put, net profit margin represents what’s left of your business’s earnings for a period of time after you subtract operating and non-operating expenses. In this article, we’ll delve into net profit margin’s meaning, how to calculate it, what a good margin is, and steps you can take to try to improve yours.
Key Points
• Net profit margin measures how much profit a company keeps from every dollar of revenue after all expenses, taxes, and costs are paid.
• To calculate net profit margin, first determine net profit by subtracting all expenses from revenue, then divide net profit by total revenue and multiply by 100 to arrive at the percentage.
• A good net profit margin varies by industry, but generally 10% is considered healthy, 20% strong, and 5% a warning zone.
• Grocery retail generally has very low profit margins, while software businesses typically have higher profit margins due to different cost structures.
• Businesses may be able to improve net profit margins by raising prices, reducing cost of goods sold, streamlining operations, and implementing better demand forecasting.
What Is Net Profit Margin?
There are three types of profit margins: gross, operating, and net. Gross profit margin is the earnings after subtracting the cost of goods sold. Operating profit margin takes into account all overhead and operating expenses. But net profit margin measures total earnings after all costs, including taxes.
To put it another way, net profit margin is how much of a company’s earnings is left after deducting all the operating and non-operating expenses in a given quarter or year. It measures how much profit a company keeps from every dollar of revenue after all expenses, taxes, and costs are paid. Net profit margin is often called “the bottom line” because it appears at the end of the income statement. It’s the most comprehensive measure of a business’s overall profitability.
It’s also one of the most common business loan terms to know if you’re a small business owner.
That’s because net profit margins are a key metric when you’re applying for small business loans. A high margin can suggest to the lender that your business can comfortably service debt while covering operating needs.
How To Calculate Net Profit Margin
To calculate net profit margin, you’ll first need to determine the net profit. Net profit is revenue minus all expenses. After you’ve calculated that, you can use the following formula to arrive at your net profit margin:
(Net profit / revenue) x 100 = Net profit margin
For example, if your business has a revenue of $600,000 and a net income of $60,000 after all expenses, your net profit margin is ($60,000 / $600,000) x 100 = 10%.
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What Is a Good Net Profit Margin?
What is considered a good net profit margin will vary depending on the industry. For example, grocery retail generally has very low profit margins, while software businesses generally have higher profit margins. In general, a profit margin of 10% is healthy, 20% is strong, and 5% is a warning zone.
What Is a Reasonable Profit Margin for a Small Business?
If you’re wondering what a reasonable profit margin for a small business might be, there’s no one clear answer. The average profit margin for a small business varies by sector. Service businesses often have higher profit margins (15%-20%) than retail or manufacturing (5%-10%).
Small businesses may also face challenges when starting out that can impact margins. If your small business needs help starting out, funding options like working capital loans might be useful.
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Can Profit Margin Be Greater Than 100%?
A profit margin can’t be greater than 100% because it’s a measure of profit relative to total revenue. Even a 100% profit margin is attainable only if your business’s costs are zero. That means that you’re selling something that costs you nothing to acquire or produce. Some examples of a potential 100% profit margin include reselling a product that you obtained entirely for free and selling information products like eBooks or online courses when the creation cost is minimal and there are no recurring inventory expenses.
It’s possible to have a markup exceeding 100%, however, since markup is the difference between the cost of a product and its selling price, expressed as a percentage of the cost.
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How to Improve Your Net Profit Margin
There are a few ways you may be able to improve your net profit margin.
One approach is to increase the prices that you charge your customers. This can make sense especially if your costs increase or demand rises for your products.
You could also reduce the cost of goods sold by renegotiating supplier contracts, switching to more affordable vendors, or taking advantage of bulk order pricing offers.
If you have a more established business, you may be able to streamline or eliminate potential inefficiencies to save money. In some cases, you could also reduce holding costs by implementing better demand forecasting and purchasing discipline.
The Takeaway
If your small business has a disappointing net profit margin, don’t panic. There are ways to improve your net profit margin. And remember that what is considered a “bad” or “good” net profit margin will also vary by industry.
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FAQ
What’s the difference between gross, operating, and net profit margin?
There are three types of profit margins – gross, operating, and net – and they’re all represented as percentages. Gross profit margin considers a company’s earnings after the cost of goods sold is subtracted. Operating profit margin takes into account all overhead and operating expenses – but not taxes or interest. Net profit margin indicates the total earnings after all costs, including taxes and interest, are subtracted.
Is a 20% profit margin considered high?
A 20% profit margin is generally considered strong, but precisely how it’s evaluated will depend on the industry. For example, grocery retail generally has very low profit margins, while software businesses usually have higher profit margins. In general, a profit margin of 10% is considered healthy, 20% is viewed as strong, and 5% is interpreted as a warning sign.
How often should you review your net profit margin?
Most businesses should review their net profit margin at least quarterly. Some businesses in fast-changing industries or high-volume operations may want to review their net profit margins more frequently, such as monthly or even weekly.
What is a bad net profit margin?
Net profit margins below 5% are usually considered to be a bad sign, but it depends on the industry.
Does net profit margin account for taxes and interest?
Net profit margin includes interest and taxes. To focus purely on operational efficiency without those factors, you could use operating profit margin.
Photo credit: iStock/Drazen Zigic
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