Profit margin is the percentage of revenue left after all costs have been subtracted.
What Is Profit Margin?
Profit margin is the percentage of revenue left after all costs have been subtracted. Production costs, taxes, fees, and wages are all deducted. What remains is how much a company is making per unit or sale.
You can calculate your profit margin with the help of this formula:
Profit Margin = (Total Sales – Total Expenses) / Total Sales
This is expressed in terms of percentage. If a company makes $1,000,000 in revenue and has expenses of $800,000, it will have a total revenue of $200,000. This will make the profit margin 2%.
A company’s total expenses include everything that will cost it money during the production and sale of its products. These expenses will include:
All these costs combined will be offset against the sales income, and whatever is left over will be net profit. These profits can then be reinvested or used to improve the company.
The Importance of Profit Margin
Companies use their profit margin as a way of determining how profitable and healthy they are. The higher their operating profit is, the more secure they will appear in their overall industry.
A company’s profit margin can help highlight the following aspects of its business:
By examining this data, owners can see which areas of the company need improving. For example, if raw material costs are too high, alternative stocks can be sourced to boost profits.
It should be noted, however, that high revenue does not always increase profits. Generally, revenue comes as a result of high expenses. If more sales require more costs, then the operating profit for production will either drop or maintain the same level as before. The key is to keep costs low while still maximizing revenue.
Profit margin can also be useful for comparing your business with others in your industry. When doing this, make sure to consider cyclical and seasonality trends, especially when comparing profit margin over a specific period.
How to Increase Profit Margin
There are many ways to improve a profit margin across the entire scope of a business. Some involve making changes to the business’s process, and others in how they make their products. Here are a few examples:
1. Reduce Operating Costs
Many operating costs go into a company. Everything from material costs to wages and employee benefits falls under this category. The key is to find which aspects of these costs are most effective and which are least.
For example, it is tempting to buy cheaper materials for manufacturing, but this will usually result in lesser quality products. Cutting back on employee benefits is a good area to look at, but it comes with causing dissatisfaction or reluctance in staff. It pays to study each cost involved in the production and weigh up which will be most detrimental to lose. Sometimes sacrifices must be made, but not at the expense of revenue.
2. Increase Average Order Value (AOV)
The AOV is how much each customer spends per transaction. Whether buying a single item, a set of items, or a collection of random items, the average cost is calculated from these figures.
You can improve the AOV of a transaction by giving customers an incentive to buy. The simplest way to do this is to offer product bundles or special offers. By increasing the perceived value of a purchase, the customer will buy more, more often.
Upselling is another common means. Ensuring customers buy an additional or more expensive version of the item they are after improves revenue and net profit. This can be done both in-store or by-product recommendations online or by email.
3. Create Customer Loyalty Programs
One of the best ways to keep customers coming back is by giving them rewards. Customer loyalty programs have become very popular in recent years as they inspire regular patronage. It is a fact that it is cheaper for a business to keep the same customers they have than to court new ones.
Loyalty programs create a warm and welcoming atmosphere while building relationships between the company and customers.