Of course, money isn't everything. But, for start-up founders, it's the top priority. You can tell vendors, investors, and loan officers that you want to make a difference in the world, but they will be more interested in financial metrics, especially your profit margin.
Net Margin vs. Gross Margin
There are two types of profit margins. Small business owners use the gross profit margin to measure the profitability of a single product. If you sell a product for $50 and it costs you $35 to make, your gross profit margin is 30% ($15 divided by $50). Gross profit margin is a good figure to know, but probably one to ignore when evaluating your business as a whole.
Net profit margin is your metric of choice for the profitability of the firm, because it looks at total sales, subtracts business expenses and divides that figure by total revenue. If your new business brought in $300,000 last year and had expenses of $250,000, your net profit margin is 16%.
Consider the Industry
Let’s say that you own a bakery. You make some of the best wedding cakes in town. You kept really good records and, after doing the math, came up with a net profit margin of 21%. Your friend owns an IT company that installs complicated computer networks for businesses and has a net profit margin of 16%. Are you a better business owner because your profit margin is five percentage points better? It actually doesn’t work that way, because profit margin is industry-specific.
Business owners make higher margin in some sectors compared to others because of the economic factors of each industry. For example, if you are an accountant you could expect margins of 19.8%. If you’re in the food service business, you might only see net margins of 3.8%. Does that mean you should sell your bakery and become an accountant? No. Profit margin doesn’t measure how much money you will make or could make, only how much is actually made on each dollar of sales.
If you’re a consultant, your margins are likely quite high since you have very little overhead. You can’t compare yourself to a manufacturer who rents space and equipment and who must invest in raw materials.
New Company vs. Mature Company
Many new business owners believe you should expect to have a lower profit margin in the beginning. Of course, it depends on your field – but, in most cases, that’s surprisingly not true. In the service and manufacturing industries, profit margins decrease as sales increase. The reason for that is simple: Businesses in these sectors may see a 40% margin until they hit around $300,000 in annual sales. That’s about the time where the business has to start hiring more people.
Each employee in a small business drives the margins lower. One study found that 90% of all service and manufacturing businesses with more than $700,000 in gross sales are operating at under 10% margins when 15%-20% is likely ideal.
In the beginning, when a company is small and simple, margins will likely be quite impressive. You don’t have a large workforce and other substantial overhead expenses. As your sales increase and your business grow, more money comes in. But your margins will likely shrink because you’re probably hiring more people, investing in bigger facilities, and expanding your product line. Simply bringing in more cash doesn’t mean you’re making a bigger profit.
And as your business grows, continue to tend to its margins. Larger sales figures are great, but make sure you're making maximum money on those sales.