Profit margins refer to the % of total revenue that remains after all costs, taxes and other expenses have been deducted. It allows you to assess how much profit your company is making on every dollar of sales earned.
Calculating Profit Margins
Profit margin can be easily calculated using a simple formula:
Profit Margin = (Total Sales – Total Expenses) / Total Sales
Here is a simple example of how it works:
Let us assume that your company made $100k in sales last year. After deducting all of your costs and expenses, such as rent, salaries, cost of goods, you’re left with net profits of $60k. Now, all you need to do to calculate your profit margin is to divide net profits by total sales.
$50k / $100k = 0.5, or 5%, as profit margins is typically expressed in percentages.
Why does Profit Margin matter?
Profit margins are a popular and simple ratio for assessing a business’s financial health and profitability. In general, profit margin can provide a decent overall insight about the different aspects of a company’s financial performance, such as
- The profitability and stability of a business
- The ability to manage expenses
- Current pricing strategy
- Business’s performance vs. competition
- Potential for getting investments
Low-profit margins could suggest a number of issues, from inability to efficiently manage expenses and overheads, to inadequate pricing strategy.
It’s extremely important for you to monitor your profit margin closely, as it’s a great tool to identify areas ripe for improvement and optimize your earnings.
Interestingly enough, higher revenue does not always translate into a higher profit margin.
If expenses associated with higher sales have increased more than the revenue, the company can end up making less money. Which is why, keeping the costs low, effectively managing the inventory and optimizing the pricing strategy for maximum profit is as much a determining factor for healthier profit margins as increased sales. Which is why you should check out our article on finding the perfect product.
Essentially, there are only two ways for companies to achieve better profit margin:
- Generating more revenue while keeping the costs low
- Lowering the costs of running the bussiness while generating the same amount of revenue
Since generating additional revenues is often more difficult, businesses typically experiment with revenue optimization strategies and tend to look for opportunities to cut down on costs and fine-tune their pricing strategy to improve their profit ratio.
Another thing to take into account is the seasonality and cyclical sales trends when comparing profit margin over a specific time period.
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