How Healthy Is Your Small Business’ Profit Margin?Knowing how your profit margin stacks up against the industry average can be helpful — if you know how to interpret the info.
Among the litany of accounting concepts small business owners are expected to understand (or at least be familiar with), profit margin is mercifully one of the simplest. It’s a direct measure of how much profit your business racks up for every dollar of revenue — pretty intuitive.
But you can learn a lot from the humble profit margin, like how your business performs compared with others in your industry. And you should be tracking whether that margin is going up or down over time, since it provides insights into the health of your business.
Gross vs. net margin
It may help to define some terms. Gross margin is your revenue minus the cost of making or acquiring it, known as the Cost of Goods Sold (COGS). Divide that result by the revenue to get the gross margin percentage.
“Gross margin should be consistent on a month by month basis regardless of whether you had a good or bad month,” advised Ruth King, “profitability master” and author of “The Courage to be Profitable.” “If you see changes, it might mean something has gone awry with your cost of materials, for example.”
The gross margin is a good way to ballpark the profitability of selling your products, but it is missing a lot of nuance. That’s where the net margin comes in. It includes not just the COGS, but all of the expenses associated with your business — all of your overhead including employees, rent, utilities, and so on. Your net profit margin is the percentage of total revenue you get to keep after every cost and expense has been accounted for. (Convert your net profit to a percentage by dividing the result — revenue minus all costs — by the revenue.)
Benchmarking your profit margin
There’s no single gold standard for what a profit margin should be. Margins vary based on factors like your industry as well as the age or growth trajectory of the business. But knowing the average profit margin for your industry can help you understand how your business stacks up.
One way to see industry averages is by using a tool such as the industry summary chart at Yahoo Finance. It lists key indicators, like P/E, ROW, and, of course, net profit margin, for more than 200 industries. Check out the average net profit percentage for restaurants (7.5), jewelry stores (7.6), auto parts stores (8.1) and more.
But beware: It can be tricky to interpret margins. If your net profit margin is higher than that of your peers, it could mean you are one of the leaders of your industry. “But it might mean that
you’re failing to include all of your overhead in the calculation,” warned King. “For example, a lot of LLCs neglect to include the owner’s salary.”
If your margins are low
Younger businesses often have lower margins because the owner is aggressively growing it, which adds to overhead and sacrifices short term profits. If that describes you, King recommended treading carefully. “A lot of companies grow themselves out of cash. If you grow too quickly, you end up in a no-man’s land where you run out of cash to operate the business before additional profits can catch up.”
Bob Shoyhet, CFO of Melillo Consulting, agreed. “If you’re investing for growth, your margin will be lower. But eventually, if you don’t start to meet your goals, you need to cut costs. You can only invest for so long without correcting.”
Industry averages give you a data point that might serve as its own goal. Said Shoyhet, “If your profit margin is below the average — say it’s 3 percent and the average is 6 percent — you can ask yourself how you can get there too.” That might mean raising prices or cutting overhead.
While it’s good to know your industry average, experts warn against focusing too much on how you measure up. “You should be comparing yourself to yourself,” said King. “If you obsess about how you compare to the industry as a whole, you could miss a downward trend in your own margin over time, which is a signal something is wrong.”