To increase the profitability of your business, you need to understand two key concepts: profit margins and profit drivers.
Profit drivers are factors that affect your bottom line. They can be:
- financial, such as the price of goods, sales volume or inventory
- non-financial, such as productivity, market share, customer satisfaction, etc
Understanding these factors and how they relate to your profit margin can help you develop strategies to improve your profits, increase sales revenue and reduce your costs.
Work out your profit margin
Gross profit is the money you have after you deduct the cost of making and selling your product. The formula is simple: Sales revenue - Costs of goods sold = Gross profit.
For example, if your business' revenue is £300,000 and the costs of goods sold is £100,000 - this leaves you a gross profit of £200,000.
To work out your gross profit margin, you divide your gross profit with the sales revenue. Then multiply by 100 to express this margin as a percentage. Using the example above, you would get a profit margin of 60 per cent.
To work out your gross profit margin percentage, you can use the following formula:
(Gross profit ÷ sales revenue) x 100 = Gross profit margin percentage
To calculate net profit, deduct from gross profit all other business operating expenses, such as interest and tax.
Is profit margin important?
Yes. Profit margin gives you valuable information about the financial health of your business. You can use profit margin to:
- Assess your business' current performance - if your profit margins are stable, this could tell you that your business is running well. However, decreasing margins could indicate problems and flag up issues around pricing, sales, costs, etc. You may also use profit margins to benchmark your performance against other businesses in your sector or industry. See how to measure performance and set targets.
- Manage your costs - for example, rising costs will show in your profit margin. You may want to find ways to reduce waste, manage your resources and deal with hidden costs. See how to reduce business costs to increase profits.
- Increase efficiency - productivity can help improve or reduce profit margins. Staff are a big expenditure for most businesses. Helping them become more effective means you'll get more output for your money. See how to improve productivity to increase profits.
- Review your sales processes - if your margins are small, you may want to consider which customers are the most profitable to your business. This may help you effectively target those customers that are likely to buy more from you. See how to target your most profitable customers. You may also want to look at your product lines - for example, stop selling products that eat into your profit margin and concentrate more on your successful lines.
- Identify new business opportunities - if your margins suggest that certain products or customers are more profitable, you may want to look for opportunities to sell more to or sell complementary products to profitable customers. You could also enter new markets to increase profits.
Using some or all of these strategies could help to increase your profit margins. You should include these measures in your business plan. See how to prepare a business plan for growth.