The goal of every small business owner is to make a profit from what they offer. One of the ways some of these business owners achieve this is by focusing on increasing their profit margin. As a newbie, profit margin and how to calculate it might sound and look strange to you.
If your business doesn’t have high overhead costs like we see in some food-related and retail businesses, your profit margin as a small business should range between 7% and 10%. That’s the average you should watch out for. Anything below that is considered low. A business that is doing so well should aim higher than that.
We’ll be making it very simple to understand in this blog, and for old business owners, you’ll also get some tips on how a profit margin can be improved. The general rule of thumb for every profitable business is, “Make more money than you spend.” This is why profit margin is one of the most vital metrics for tracking your business.
An easy explanation of profit margin is that it is a percentage of dollars you keep as profit, gotten from your total business revenue. Therefore, in logical order, the higher the percentage profit margin, the more profit you make. This is the reason your business depends on profit margin as the most important financial ratio.
What businesses have the best profit margin?
when thinking of a business and making plans for starting up. You also have to consider other factors which may negatively affect the business. Your skills, personal interests, and the demand for your service are very important. These factors affect your profitability. If you find yourself in a business where you always have to put in more of your personal money, you won’t be handling that business for a long time.
Some businesses with the best profit margins include:
- Social media management
- Home improvement
- Virtual assistant
- Tutoring services
- Business consulting
- Cleaning services
These businesses basically do not require much capital or labor, and they can make their profits almost immediately after they start. That is why we have included them in the list.
How do you determine profit margin?
You have likely heard about new businesses making $200,000 or even more in their first year. While you are convinced and impressed, you should note that the revenue obtained from a business does not give you the full knowledge of its success. It is unimpressive if a business owner makes a profit of just $1,000 out of a total revenue of $100,000.
There are three profit metrics a business owner can use to ascertain profit. These metrics can also be used in comparing profits made between multiple businesses and assessing a single business’s profitability.
Gross Profit
When you make 0 as a gross profit on a bag that cost 0 to produce and sold for 0, it means you profited 50% of your revenue. Gross profit is simply removing your cost of production and items sold from the revenue.
Your gross profit margin is obtained from the division of gross profit by revenue and obtaining a percentage.
Gross Profit Margin = (Gross profit ÷ Revenue × 100)
i.e., the gross profit margin for our initial illustration is 50% ($200 ÷ $400 × 100)
Operating Profit
The amount left after you have subtracted the operating expenses and cost of items sold from revenue is called the operating profit. It tells you how much you have profited after all expenses, which include interest and taxes.
Operating Profit = Gross Profit ‐ Operating Expenses.
Operating Profit Margin = Operating Profit ÷ Revenue × 100.
Net Profit
The net profit is what is left after taxes, interest, and expenses have been removed. It accounts for all expenses. This makes it the most accurate way to assess a business’s profitability.
Net Income = Operating Profit – Tax Expenses – Interest Expenses
Net income margin = Net income ÷ Revenue × 100
What is a bad profit margin?
The profit margin of a small and simple business will initially be appealing. This is because the labor, workforce, and expenses are quite minimal. With time, as the business gets larger, you generate more money. However, you also notice that the margins are also reducing even with more cash being made.
A “bad profit” is recorded when the amount spent on production and expenses is greater than the revenue or profit made. This simply means making less revenue than total spending. You know you have a negative profit margin when you have to reach out to more investors or request loans.
Making a remarkable sale is perfect for any business. But as you employ more people, invest in bigger machines, and even extend your business, double check that you are not spending more than you are earning.
What causes low profit margins?
The percentage of cash you keep after all expenses have been paid is your profit margin. It can be used to reinvest or settle shareholders in your company. A low profit margin can put a stop to these and even keep your company indebted.
Below are some reasons why your profit margin may be affected negatively.
- Increased interest rates
- Decreased demand for products and the recession.
- The cost of raw materials and labor
- Competition
- Poor marketing skills
- Underpriced goods
- Reduction in revenue.
Most of the time, a low profit is unavoidable. You just have to study your business flow, adjust the prices of goods, increase marketing when costs of raw materials increase, change location, employ an active workforce, and shuffle labor work.
How can you avoid loss in your business?
When a business plan is made, that is the best time to write down fresh ideas and vital details. A structured business plan will help curtail potential challenges you may face and open your mind to where your opportunities can be mined.
When a business begins, it could be fair weather till obstacles strike. Many business owners can not even point out the causes of these losses. Some of these causes could be
- Wrong planning and lack of control and coordination
- Lack of skilled labor.
- Bad maintenance of equipment and working tools.
- Diversion of funds
- Combining business and personal money
- Insufficient finance and funding.
To prevent business loss, which could lead to a fold up, do the following:
- Make sure you have a limit on your monthly cash expenditures and cash flow.
- Purchase raw materials or goods after multiple quotations have been gotten from different suppliers.
- Always keep stock of raw materials.
- Have a financial and fund-raising plan. This should take place at least 5 months ahead of time.
- Avoid combining business with personal properties.
- Take note of even the smallest equipment leaving the building for either maintenance or rent. This is to track theft or fraud.
Losses in business are not what any owner expects when starting up. Make sure that you are not rendering a service that is not in high demand or not even needed in the area or region that you are in. Also, take note of the competition you face with other businesses. Take time and change a general method and a general norm just to be unique.
Do businesses make profit first year?
Business owners who make a break in the first year should be significantly applauded. Considering the capital and one-off costs when starting a business, we do not put much pressure on these owners if they have not made profits in the first year. Getting off the ground and recovering the money spent on machines, buildings, and other expenses is not expected in the first year.
In the first year of a new business, what is important is not to make a profit. It is recording how much you make each month, calculating your profits on them, and making sure that in the next 3 years you will have made enough to cover your capital. You also need to do a monthly review on the trend your profit is taking. How fast is it increasing or declining?
However, a few companies still make profits in their first year. Some of these companies actually lose these little profits to taxes or try to expand the business by hiring new laborers and extending the type of service they offer.
How long does it take for a small business to succeed?
The time it takes for a small business to succeed is solely dependent on its management and some other factors, which include the sector of business you operate in and its demand, the nature and consistency of important business necessities.
There is actually no fixed or estimated time to expect profit from your new small business. As a matter of fact, many businesses do not get stable till they get to their third year. Some take five, and, as expected, they fold up before then.
Many companies make a profit even from the first day of work. These are, however, businesses that do not necessitate extensive operations and innovation. Others, such as retail, may take so many years to attain a position of profitability. This is because capital outlay is not the same in every business.
What percentage of businesses fail in the first year?
Every business comes with its own risk, and as a business owner, you should be prepared for that risk. It might sound discouraging to you as a new business owner. But most of these failed businesses were caused by so many factors. Some could have been avoided, while others were just unavoidable.
According to the Small Business Administration, 20% of small businesses failed in their first year, while about 45.5% ( an unstable amount because of the differences in years) survived the first five years. Just about 3 small businesses stayed for up to 10 years.