The profit margin is a financial tool that helps you assess how your business’s bottom line is doing. Generally speaking, a higher profit margin means that your business is doing well. However, what a “good” profit margin depends on a variety of factors.
Calculating your profit margin is just the first step. Once you have the number, how can you tell if your profit margin is good?
Good Profit Margin
Net profit margin analysis is tricky. There is no universal rule like “every business should at least have a 20% profit margin.”
Benchmarking is the key to determining if your profit margin is good. Since profit margin is a tool that is meant to be used for standardized comparison, defining what a good profit margin is varies a lot, depending on the market conditions. Generally, getting a 10% net profit margin signifies that your business is doing average. Reaching 20% is considered high, meaning your business is very profitable while getting 5% means you’re doing poorly and might need to change pricing strategies.
However, as mentioned before, these guidelines vary widely depending on the industry sector you are in, as well as your business size. There are also a lot of other factors that can affect the analysis of your profit margin.
In a nutshell, your profit margin is good when you outperform or at least meet your industry’s standards.
Let’s take a look at some common scenarios and analyze the factors that play a role in defining a good profit margin.
Money might not be everything, but for new business owners, it should be your top priority. You might have started your business with a great vision of wanting to make an impact and change the world. However, it is crucial to have a good profit margin to sustain a business, especially a world-changing one! Vendors, investors and loan officers will look first to your financial metrics before potential.
Prior to starting your business, you should do your research about the industry you are entering. Know what the industry standards are in terms of profit margin, and make it your goal to go higher than the average.
For startups, you might also need a more frequent calculation of your profit margin to monitor the success of your products. During the “trial-and-error” period, you need to see which products are profitable and which ones might need more time on the drawing board.
Different industries have different economic factors, and subsequently varying profit margin averages. For example, in the food industry, you might see profit margins of 3.8%, while in the consulting business, net profit margins can go as high as 40%. Does this mean the food industry is less profitable than consultancy? Not really.
Sectors like the food industry have higher overheads brought by higher raw material costs due to spoilage, expensive equipment. Therefore, it is understandable to see lower values for profit margins in this sector, as the total expenses are usually high. However, what they lack in a low margin, they make up for in terms of volume and stability of revenue. Other sectors like consultancy have relatively less expenses, so it is natural to expect higher values for profit margin.
As a result, inter-sector comparisons of profit margins are inaccurate analyses. In order to accurately gauge if your profit margin is good, you need to focus on the industry you are in.
Statistics show that businesses in the service and manufacturing sectors see a 40% profit margin at the beginning, and a decline is visible around the time they hit around £240,000 of annual sales.
It is a common expectation among new business owners that they will have lower profit margins at the beginning, and it will grow higher as time goes by. However, this isn’t the case. Depending on your field, especially in the service and manufacturing industries, profit margins decrease as sales increase.
This situation is bound to happen as you scale. As your business grows, you hire more people, and every new employee drives the profit margin lower. You also need to rent more spaces to expand your service and accommodate more customers, and as a result, you pay more bills. As mentioned in the above example, you should be making a profit by bigger volume with more substantial machinery.
Your profit margins will appear impressive when your company is still small and simple because you wouldn’t have a large workforce in your payroll, and your overhead expenses would be minimal. Take advantage of this momentum to inject more working capital so you can scale as the demand for your product or service grows.
A good profit margin depends on the industry sector you are in, your company’s maturity and stability, your future goals for the business, and the economy. Your goal as a business owner is to study the industry, monitor the changing trends and standards set in that sector, and make sure that your business meets or outperforms those standards.
Knowing your profit margin helps you determine the next steps you should be taking. This is especially true when you are planning to expand your business. A “good” profit margin might not be good enough when you are getting ready to bring your business out of its comfort zone. Keep in mind that its analysis is different for every business; you need to be specific to be effective.
All these factors to consider might be very confusing for some business owners, especially for those who are just starting. If you are having a hard time analyzing whether your profit margin is good or not, hiring an expert might be for the best. They are well-versed in the complex relations of the different economic factors in the industry, and have a better handle on understanding and interpreting the figures for you.
Ultimately, larger sales figures are great, but your priority should be in maximizing the profit conversion of those sales. That’s why tracking and maintaining a good profit margin is essential for your business’s success.
One way to manage your finances is through the professional services of an accounting firm. Annette Ferguson – Chartered Accountant and Certified Profit First Professional – can help you unlock financial strategies to improve the profitability of your business amidst an economic crisis. Book a call with us. You can also follow us on any of our social media channels and subscribe to our YouTube channel.