Every business has an appropriate range of profit margins. Your business must stay within that profit range, or could suffer negative consequences. This is especially true in a tough economy, and here’s what business owners need to know to survive.
Every business owner must understand the basics of profit margins for effective financial management. You should know your business’ appropriate margins and you hit these margins each month.
There are 3 primary profit margins: (1) gross margin; (2) operating margin; (3) net income margin. Here’s how to calculate each.
Gross margin is your gross profit divided by revenue. Gross profit is calculated by taking revenue and subtracting the cost of goods sold. Your cost of goods sold are direct costs that only happen when you sell something and earn revenue. Examples would include (1) labor costs of producing your good or service; (2) supplies needed to produce your good or service; or (3) sales commissions for the good or service. Theres are DIRECTLY related to production of your good and service and only increase or decrease as sales go up or down. They are NOT fixed.
Operating margin is the operating profit divided by revenue. Operating profit is found by taking gross profit and subtracting sales, general & administrative expenses (SG&A). These are also called indirect costs, because they are generally fixed even when sales go up or down. Rent is a great example, because your landlord doesn’t care if you you had a good or a bad month. They want the same rent each month.
Net Margin is net profit divided by revenue. Net profit is found by taking Operating Profit and subtracting non-operational income and expenses like interest and taxes. Many businesses just track Net Profit instead of bothering with operating profit, and that’s fine depending on the size of your business. However, the larger you get and the more you intend to exit your business, the more it makes sense to track this separately.
To review:
Gross Margin = Gross Profit divided by Revenue
Operating Margin = Operating Profit divided by Revenue
Net Margin = Net Profit divided by Revenue