Companies like yours need to turn a profit to stay in business. Understanding what’s a good profit margin is important when managing your company’s finances.

Profit margins can vary by month, season, industry, and how they’re calculated. There are also different types of margins you’ll need to understand and ways to improve them. But let’s start with the basics. 

What Is a Profit Margin?

A profit margin is an amount that shows how profitable your business is by dividing income by revenue (also called sales). The profit margin is expressed as a percentage and shows how many cents in profit you earn for each dollar in revenue.

Analyzing financial data

According to Industry Canada, profit margins vary by the size of a business. For example, in 2012 (the latest statistics available), small businesses (those with annual revenue of less than $5 million) had a net profit margin of 7%. Medium-sized companies (those with annual revenue of $5 million to $25 million) had a profit margin of 3.7%, and large businesses (those with annual revenue of $25 million or more) had a profit margin of 5.6%.

Profit margins also vary by sector. Market research firm IBISWorld finds that the businesses with the highest profit margins in 2022 are as follows:

  • Payroll and bookkeeping services: 33.8%
  • Human resources consulting: 27.9%
  • Tax preparation services: 26.8%
  • Breweries: 25.8%
  • Real estate sales and brokerages: 24.9%
  • Fishing and seafood aquaculture: 22.4%
  • Thermal power: 19.6%
  • Wood panelling manufacturing: 17.5%
  • Public relations: 16.3%
  • Wheat farming: 14.5%

Calculating Profit Margin

There are three different types of profit margin calculations. The net profit margin is the most comprehensive and takes into account all expenses. The gross profit margin only includes the cost of goods sold (known as COGs), while the operating profit margin falls between the other two.

Here’s an overview of each one:

1. Net profit margin

The net profit margin measures how much net income is earned. All expenses are included in the calculation. That includes costs of goods sold, operational expenses, debt and tax payments, one-time fees, and income from secondary operations or investments. Business insurance is an expense and can also be deducted for tax purposes.

To calculate this type of profit margin, you need to subtract your cost of goods sold, operating expenses, other expenses, interest, and taxes from your net revenue (gross revenue minus discounts, returns, and allowances). Then divide that amount by revenue and multiply the result by 100.

2. Gross profit margin

The gross profit margin shows you how much your business makes after paying for production costs. There are fewer steps involved in this calculation. You only need to subtract the cost of goods sold, which is the cost of labour and material used to create the good. You don’t need to include expenses that involve distribution, sales, or marketing.

You subtract the cost of goods sold from net revenue, divide it by net revenue, and multiply the result by 100 to get the gross profit margin.

3. Operating profit margin

Finally, there’s the operating profit margin, which measures how much the business earns before interest and taxes (usually referred to as EBIT). You need to subtract your cost of goods sold, operating expenses, and depreciation and amortization from your revenue to get the operating income amount. Then divide that amount by net revenue and multiply the result by 100 to get the gross profit margin.

Why Should You Calculate a Profit Margin?

Profit margins are necessary for measuring performance against previous results and your competitors (Industry Canada has a financial performance data tool you can use as a benchmark). They can also help identify problems and where improvements can be made.

Profit margins are also important for your stakeholders. For example, financial institutions and investors will want to know your margins before deciding whether to lend you additional funds. 

Cash Flow and Profit Margins

Cash flow is the money that moves in and out of a business during a specific period, such as a week, month, quarter, or year.

Cash flowing into the business can result from a sale or a payment received from an installment plan. Cash flowing out of the business can be due to inventory purchases and paying your employees’ salaries or rent for your office space.

There can be both negative and positive cash flow. Negative cash flow means more money is moving out than coming in, while positive cash flow means the opposite.

It’s also essential to measure cash flow because of its impact on your profit margins and your overall profitability. Looking at both can give you a better idea of your company’s financial health and performance.

While your business may be profitable, not having enough money to pay your bills or your staff can make or break your company, making sound bookkeeping practices essential.

How to Achieve Profit Margin Goals

Setting profit targets will help keep your business focused. You may have many goals you want to achieve, but getting there can take some work.

You and your team must agree on the way to reach these goals. Once these targets are set, it can help if you make certain employees responsible for each goal.

Some goals may include increasing revenue, improving margins, and lowering costs. You need to have specific targets, such as a 10% increase in annual revenue or a 5% decrease in expenses.

These goals also need to be reviewed regularly to make sure everything’s on track. You can make modifications along the way if you’re below or ahead of your targets.

How to Improve Your Profit Margin

There are many ways to increase margins. Here are a few:

  • Raise prices. In today’s inflationary environment, costs for goods and services are rising. Passing these costs onto your customers will help improve revenue. However, raising prices by too much may lead to customer loss and a potential decline in revenue. It’s best to review your pricing strategies often to see what the market will bear.
  • Negotiate discounts and payment terms with vendors. Talk to your vendors to find out if there’s an opportunity to get discounts on products or services. Also, ask if there’s the ability to get a discount on invoices if you pay them early.
  • Cut back on discounts. Although discounts can lead to a quicker sale, they can also impact net profits. Consider using smaller discounts or getting rid of them altogether.
  • Reduce labour costs. While layoffs should be a last resort, you can cut employee costs by using fewer contract workers (who usually get paid more than full-time staff) and reducing overtime. However, make sure that your employees aren’t overloaded with additional work because of these changes.
  • Look for government incentive programs. Both federal and provincial governments offer a variety of wage subsidies, tax credits, and grants for small businesses. An external business advisor or mentor can usually help you find what’s available and help with the application process.
  • Cut wasteful spending. Is your company paying for goods and services you no longer use? Do you have empty office space that can be sublet? Look at every minor or major expense and what can be cut without affecting your business.

Protecting Your Business Can Improve Profitability

Profit margins are an important measurement to determine how your company is doing. While they may fluctuate from time to time, your overall goal should be to improve them over the long term while also growing your business.

Lastly, ensuring you have adequate business insurance to protect your small business from damage and loss is vital for ensuring your profit margin remains robust. Even one frivolous third-party lawsuit or the cost of damages resulting from an unexpected event such as a fire could bankrupt your company.

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About the Author: Craig Sebastiano

Craig Sebastiano is an award-winning business writer based in Toronto. He has written for a variety of financial publications and websites. He has written about several topics, including investing, insurance, real estate, mortgages, credits cards, banking, pensions, saving for retirement, and taxes.