What is a profit margin?
A profit margin is a financial metric, expressed as a percentage, that reveals how much of a business’s revenue is profit after the costs required to operate and produce products have been deducted.
If a business generates a 20% gross profit margin, then every dollar in revenue costs 80 cents to produce and sell – the remaining 20 cents is gross profit.
There are four common metrics for measuring profitability:
- Gross profit margin
- Net profit margin
- Operating profit margin
- Earnings before interest, taxes, depreciation, and amortisation (EBITDA)
Gross profit margins are useful for determining a single item’s profitability while net profit margins are better for measuring the overall profitability of a company. Operating profit and EBITDA provide additional ways of valuing how profitably a company operates.
Profit margins are an important indicator of your business’s financial health. They’re relied on by stakeholders including lenders, investors, and business partners to understand a company’s prospects.
More importantly for business owners: profit margins can be used to inform business strategy and predict income so that you can plan resources and allocate budget accordingly.
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What is a good profit margin?
A good profit margin is one that supports business growth and continuity without requiring pricing that scares away customers. The exact figure varies depending on industry, business size, and growth strategy.
However, we can make some generalisations about good profit margins:
- A net margin of 10% is generally regarded as a good profit margin for most business types, while 20% or higher is very healthy. A 5% net profit margin is regarded as low and indicates the business may be unsustainable.
- A gross profit margin of over 50% is healthy for most businesses. In some industries and business models, a gross margin of up to 90% can be achieved. Gross margins of less than 30% can be dangerous for businesses with high gross costs.
It’s important to mention that there’s no one-size-fits-all number that represents a good profit margin. Because of the nuances of every business and the large variance between average margins of different industries, what’s a good profit margin for one business may be unsustainable for another.
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High profit margins vs. low profit margins
One thing we can say is that higher profit margins are preferable.
A high profit margin shows that a company is effectively managing its costs and generating revenue. But it can also indicate the company is not investing enough in internal needs such as research and development or labour upskilling.
Some businesses, such as manufacturing companies, have higher operating costs when compared with, for example, retail and grocery stores. Others have high unit revenue but lower inventory turnover.
Economic conditions, sector trends, and customer demands can also affect the health of your profit margins. All these factors and more must be considered before determining if a company’s profit margin is good or bad.
Profit margin benchmarks by industry
An effective way to gauge whether your profit margins are good or bad is to compare them with other businesses from your industry.
The data in the table below demonstrates average profit margins across different sectors in 2023, based on information collated by NYU Stern:
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If there’s one thing these profit margin benchmarks can tell us, it’s that the average profitability of businesses varies greatly between different industry sectors.
The percentages in the table above are too opaque to inform all the factors that make a ‘good’ profit margin. But they paint a clear picture of the relationship between different measurements of profit – including EBITDA – as they pertain to specific business types.
Gross profit margin
Gross profit margin, also called the gross margin, is the profit that remains after subtracting the cost of goods sold (COGS) from net revenue. It’s a financial metric usually expressed as a percentage and represents the total profit made before deducting the additional sale, overhead, and administrative costs.
What is a good gross profit margin?
There are basic levels of gross profit margin which are considered low, average, or good. Generally, a gross profit margin of between 50–70% is good and anything above that is very good.
A gross profit margin below 50% is usually not desirable – though lower margins can still be sustainable for businesses with lower operating costs.
However, the figure is relative and can vary depending on your industry, business model, economic conditions, and customer trends.
How to improve gross profit margin
If your gross profit margin is sinking below 50%, run a ruler over your costs and income.
There are several strategies to increase the gross profit margin, including:
- Reduce supplier costs. Your suppliers may have been in place for some time. Assess whether they’re still offering the best deals and the product or goods you need by comparing them with other providers. If supplier costs are high, negotiate for better deals or consider switching to a new vendor.
- Optimise inventory management. Inventory carrying costs can be some of the largest in a business, but they also present one of the best opportunities for cost reduction. Small changes such as optimising your warehouse layout and investing in inventory management software can result in major cost savings.
- Minimise production costs. Better technology and manufacturing equipment can help reduce production costs, ultimately improving gross profits. Look for tools that speed up systems, communications, and the manufacturing line. These may require some upfront investment which will need to be assessed against the benefits.
Net profit margin
Net profit margin, or net margin, is the profit left over after all the necessary costs required to operate a business, produce products, and fulfil tax obligations have been deducted from a company’s total revenue. It’s expressed as a percentage and is considered the truest representation of a company’s profitability.
What is a good net profit margin?
A net profit of 10% is generally regarded as a good margin for most businesses, while 20% and above is regarded as very healthy. A net profit margin of less than 5% is relatively low in most industries and can indicate financial risk and unsustainability.
A higher net profit margin typically indicates the company is managing its costs well and generating good levels of revenue. A lower net profit margin means the business needs to consider how its costs and revenue structure could be better managed.
This analysis should be done within the context of the industry’s norms, economic conditions, and customer trends. You should also consider your overarching business strategy–achieving maximum net profit is not always the immediate goal for a company.
How to improve net profit margin
Strategies for improving the net profit margin must consider the tax structure of the business and ways to mitigate the tax liabilities. This will require advice from tax experts or accountants.
Additional ways to improve your net profit margin include:
- Increase value for the customer. Is there an opportunity to bundle products, provide better user experiences, or refine the overall product offer? Even a slight increase in average order value can boost revenue and improve your business’s overall profitability.
- Update your pricing strategy. Consider ways to make your pricing more competitive and appealing to customers. Or simply raise your selling prices to widen profit margins if you believe you can sell nearly the same volume of goods at a higher price.
- Analyse your marketing strategy. Effective marketing can give a huge boost to sales and help to increase the perceived value of your products. If your strategy is outdated or lagging, recutting it can be a smart investment of time and energy.
Operating profit margin
Operating profit margin is the percentage of revenue left over after deducting all the costs of running a business and preparing products for sale. It’s determined by subtracting operating expenses such as rent, subscriptions, and staff salaries–along with the cost of goods sold–from gross revenue.
What is a good operating profit margin?
A general rule of thumb is that a good operating profit margin sits between 10–20%, meaning the business has a profit of 20 cents on each dollar of revenue after operating costs have been deducted.
However, this can vary from industry to industry. Particularly competitive sectors can have lean operating costs due to tight margins on goods. Others with higher net profit margins at the product level will likely have higher operating profit margins at the business level.
How to improve operating profit margin
Improving operating profit margins will require a focus on the operating cosst and efficiency of the business.
Techniques for improving operating profit margin include:
- Control your operating costs. To improve your operating profit margin, consider costs right across the business, including labour. Can roles be made more efficient? Will investment in automation or warehousing equipment improve productivity?
- Audit your systems and processes. Operational costs like maintaining machinery can be expensive. It’s important to have fit-for-purpose technology and optimised processes. Conduct regular assessments of what you’re using and how you’re using it, along with what else is available on the market, to identify opportunities for improvement.
- Reduce manufacturing waste. Audit your energy use and waste production and see if there are simple ways to reduce operational costs. Consider switching to more energy-efficient light bulbs, installing automatic lighting, and finding ways to recycle waste.
What is a reasonable profit margin for a small business?
The profit margins for small businesses will vary depending on industry, economic climate, and customer or market trends. However, the rule of thumb when it comes to net profit margins in a small business: anything over 10% is good; anything below 5% should be analysed.
It’s important to note that small businesses often sacrifice higher profit margins for the sake of increased revenue. For example, a company may reduce the sale price of a particular product by 10% (and thus, its margins) and, in doing so, improve the total sales of that product by 20%.
While it’s good practice to consider industry averages, don’t let this be the sole determinant for determining the profit margins in your small business.
If you have evidence that suggests lower margins during a growth stage will lead to greater profitability in the long run, your business strategy should take that into consideration as well.
How to calculate profit margin
The formula for calculating profit margin looks a little different depending on which type of margin you’re trying to work out: gross, net, or operating profit margin.
To calculate profit margin, you’ll first need to determine:
- Your total revenue
- Cost of goods sold
- Your operating costs
In the case of net profit margins, you’ll also need to know how what percentage of revenue goes towards taxes and additional costs.
Let’s look at each of these types of profit margins and how they’re calculated.
Gross profit margin formula
The gross profit margin doesn’t include the cost of taxes and other expenses that don’t fall under the cost of goods sold. While this limits the visibility of a business’s true profitability, it can clarify how effectively a business generates cash from sales relative to the cost to produce.
The formula for calculating gross profit margin is:
((Net Revenue – Cost of Goods Sold) / Net Revenue) × 100 = Gross Profit Margin
In the gross profit margin formula, ‘net revenue’ represents the money generated from sales and ‘cost of goods sold’ represents the direct costs that went into producing and preparing goods for sale.
Net profit margin formula
The net profit margin formula helps businesses understand their true profitability, or how much of their revenue can be considered income after all direct and indirect costs have been taken out.
First, you must calculate your net profit. This will be equal to your gross revenue minus the cost of sales, interest, taxes, and operating costs. Then you can insert this into the formula below to determine your net profit margin.
The formula for calculating net profit margin is:
(Net Profit / Gross Revenue) × 100 = Net Profit Margin
In the net profit margin formula, ‘gross revenue’ represents the total sales for a company in the period being measured. ‘Net profit’ represents the income that remains after all the costs of creating and selling a product and keeping your business operating have been deducted.
Operating profit margin formula
The operating profit margin formula shows profits after the deduction of operating expenses from revenue. This metric is useful for assessing whether a company’s operating costs are high or low relative to the industry and its competition.
First, you must work out your total operating costs and subtract them from your gross revenue to determine your operating profit. Then use the formula below to determine your operating profit margin.
The formula for calculating operating profit margin is:
(Operating Profit / Gross Revenue) × 100 = Operating Profit Margin
In the operating profit margin formula, ‘operating profit’ represents the total income that remains after all operating costs have been deducted from gross revenue.
