The process that goes into the starting of a new business should not be underestimated in its importance. A business owner that methodically puts together a good business plan and executes the business plan properly has a better chance of success than someone who ignores the process.
On what exactly should a new business owner be focusing on? The details matter a great deal. The business owner needs a good grasp of where the company’s revenue will likely come from and how that revenue will match up with the company’s expected expenses.
The focus on details is critical. However, the details should fall into place to paint the most important picture. That picture would be whether or not the business holds the potential of being profitable.
All business owners are concerned with profitability. With that said, it’s interesting to note that a lot of new small business owners don’t have a good grasp on what they should target as profit margins. These are the numbers that will ultimately drive a business’s success.
We hope the following information will serve to inform prospective new small business owners of how to point their business activities towards a solid profit margin that’s sustainable.
How to Determine Gross Profit Margins
Before we turn our focus on what would qualify as a good profit margin, we thought it would make sense to clarify how a profit margin is determined. To be clear, determining a business’s profit margin is not a difficult task. It doesn’t require a team of accountants to spend hours doing calculations.
The two key numbers needed to calculate a profit margin would be the revenue from sales (goods or services) and the company’s gross or net profit. The targeting of gross or net profits will depend on which profit margin the business owner or investors want to see.
The revenue from operations is easy to determine through basic accounting. It’s simply an accumulation of all the revenue that’s acquired through sales. To get the gross or net profit number will require another calculation.
Assuming we are focusing on gross profits, we would calculate that number by taking sales revenue and subtracting the costs of goods sold to come up with gross profits from sales. Once we know the gross profit from sales, we can calculate the company’s gross profit margin by dividing the gross profit by sales revenue. The result is stated as a percentage.
It’s important to note that a gross profit margin can be calculated individually for each product or service. That kind of information is useful to business owners who are trying to identify which products or services are providing the best returns.
How to Determine Net Profit Margins
A gross profit margin signals how effectively a business’s products or services are at making operations successful. To address the overall profitability of a business, the small business owner would want to use a net profit margin formula.
That formula is done by taking the company’s gross profit from sales, adding other revenue and subtracting other expenses. The resulting number would be the company’s net profit, which would then be divided by sales revenue to get the company’s net profit margin.
note: Other revenue might include interest income, income from the sale of assets or any other revenue that comes outside of basic operations. Other expenses would include any other costs that aren’t included in the cost of sales. Those numbers might be corporate salaries, office expenses, depreciation and state/federal income taxes.
How Variables Affect Profit Margin
Now that we have provided small business owners with information about how to calculate profits margins, it’s time to set profit margin standards.
We want to state right up front that determining a good profit margin requires a business owner to take certain variables into account. Anytime variables come into play, it becomes difficult to create hard, fast rules.
With that said, let’s begin this discussion by identifying potential variables. Taking everything into account, there are three primary variables on which we want to focus:
- The industry within the business operates
- Forecasting for future expansions
- The size of the business
The Industry Within the Business Operates
Each business industry has its own “rule of thumb” business owners can use as a target profit margin. The truth is profit margins can vary widely by industry, The best way for a new small business owner to determine a good profit margin is to look at other successful small businesses in the same industry. It would also be wise to look at businesses in the same general region to avoid variances created by location.
Forecasting for Future Expansions
If a small business owner is looking to expand the business, the company will need to ramp up expenses to provide the framework for expansion. In the short-term, the additional expenses will distort profit margins until sales catch up with expenses.
The Size of the Business
The size of a business will be a determinant is the company’s profit margins. Because of cost savings given to larger businesses, larger businesses usually show larger profit margins. The size of the company refers to both revenue and headcount. One way a small business can increase its profit margins by simply increasing the company’s sales.
What is a Good Profit Margin?
Following the above discussion, it should be clear that determining a “good” profit margin is somewhat subjective because of variables. If a small business owner is looking for a hard percentage to use as a point of reference, that’s best done by finding other companies that fit a similar profile.
To be clear, profit margins say a lot about a business’s success. Investors and lenders will use profit margins to determine whether or not to get involved with a particular business or business owner. However, a company’s profit margin is generally considered good if the small business owner and/or investors are happy with the results.