Do you feel in the dark about your financial ratios? You’re not alone. I’ve been hearing a lot about Profit Margins from clients lately. Turns out there’s a lot of confusion.
Many business owners don’t realize the importance of your gross profit margin and your net profit margin. What? There’s more than one profit margin? Actually, there are lots. Let’s focus on the basics.
In general, a profit margin is the amount by which your revenues from sales exceed your expenses. Since the goal is to actually make money, we are looking for a positive number here.
There are 2 main profit margin calculations – Gross Profit Margin and Net Profit Margin. Eww, gross!?! No, not gross as in “yucky” but rather as in “without deductions.” Just like gross wages verses the after tax (“net”) amount that ends up paid in your paycheck. Gross profit margin tells you how much money is left over from sales after deducting your cost of goods sold (“COGS” – how much you had to pay to purchase/make the items you sold). It’s expressed as a percentage.
For simplicity, let’s give you a fake business. Let’s assume that you sell oranges. You buy them in bulk, perhaps let’s say you buy 4 oranges at a time (see what I did there??) and then sell them individually.
You buy the 4 oranges in bulk for a total of $4.00, but you turn around and sell them for $1.25 each, meaning your revenue from the sale of the oranges is $5.00. Your Gross Profit from the sale of the 4 oranges is $1.00.
Your Gross Profit Margin is calculated by dividing your Gross Profit (in dollars) by your total revenues (also in dollars). Here is the calculation for your new orange-selling business:
You have a 20% gross profit margin. In other words, $0.20 of every $1.00 you make ends up as gross profit. If you expand your business, you can easily calculate your expected gross profit of a larger (or smaller) expected revenue. It’s still 20% of revenues. If you sell 8 oranges, your revenues are $10. You can calculate your expected gross profit by taking 20% of $10 – it’s $2.00.
So how does Gross Profit differ from Net Profit? The difference is which expenses are included. Gross profit only counts cost of goods sold. It doesn’t count other business expenses, such as a business license, insurance, rent, salaries, etc. These kinds of expenses are commonly referred to as your “operating expenses.” It’s the cost for you to be in business.
So why does all this matter? What if you were presented with an opportunity to add a product to your company. You could sell apples and oranges. You have a great supplier who will sell you 4 apples for $3.50 and you think you can sell the apples individually for $1.00 each. What’s your gross profit margin on the apples?
You have a 12.5% Gross Profit Margin for the apples, compared with a 20% Gross Profit Margin for the oranges. So clearly, it’s a better deal for you to focus your efforts on selling the oranges, right? Maybe.
Here’s where Net Profit Margin is important. What if there was a fixed $2.50 city fee imposed monthly on businesses that sell Oranges? How does that change things?
We need to add Expenses. The city fee is a $2.50 expense – but only for Oranges. Here’s how the Net Profit Margin calculation looks for the sale of 4 oranges.
Negative 30%???? Oh, no. Not good. What about the apples?
Wait. This Net Profit Margin looks identical to the Gross Profit Margin for Apples. Yes, it does. That’s because you have no expenses to deduct in the Apple scenario, meaning that the calculation for both Gross and Net Profit Margins are the same.
Your Net Profit Margin on the sale of 4 Apples is 12.5%, as compared with a negative 30% for selling 4 oranges. If you only sell 4 apples, or 4 oranges, the city fee makes it a smarter move to focus on apples. But what if you want to sell more? Maybe 10? 20? 50?
If you’re not a numbers person, here’s where a handy chart comes in.
So, you see, since the Gross Profit on the sale of one orange ($0.25) is greater than the Gross Profit on the sale of one apple ($0.12), once you sell enough oranges to cover the fixed cost of the city orange-selling fee ($2.50), your sales strategy should switch from apples to oranges. You can even calculate exactly where that point will be. To determine exactly when to switch, let’s use these figures:
$0.25 profit per orange less the $0.12 profit per apple gives us a $0.13 difference.
$2.50 / $0.13 = 19.23. You can’t sell part of an apple/orange, so this rounds up to the next number = 20.
If you sell more than 20 oranges, you will make more money than selling 20 apples.
All this focus is to make you as profitable as possible. So why don’t we just pay attention to Net Profit (in dollars) and ignore Net Profit Margin (the percentage)?
Net Profit Margin is a measurement of what percent of profit you earn from your total revenues. It’s used for many purposes, including:
• Comparing similar businesses with different annual revenues (the business with the higher margin would be more profitable if revenues were equal)
• Forecasting profit based on revenues (what if you sell 20% more? How will profit be affected?)
• Ensuring that strategies are working (a successful marketing strategy or equipment purchase should result in a higher profit margin over time)
So, I guess what this means is that we’ve proven the world wrong. You can compare Apples and Oranges after all. You just need to understand profit margins.