How to Calculate Profit Margin

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Planning to start a new firm? Good idea! Almost 50 million new firms are formed every year; that’s twice the population of Australia. But at the same time, almost the same number of firms close every year, too.

Our inquisitive nature makes us start new ventures but how do we explain the closure of an equally big number of firms? Inability to make profit, among other factors, is responsible for closure of such a large no of firms. Making a business profitable is not a piece of cake; it is difficult and requires logical planning, well-defined strategy and wise calculations. If you are looking to form a company or even if you have already established one, you must be engrossed by the question “How to Make Your Business Profitable?” If this is the question which has been haunting you for quite a time; don’t worry! Just be with me for the next 10-15 minutes and I will help you articulate a plan to run a profitable business.

1. Define the Purpose of Your Business

Defining a business purpose is vital to business success. Once you are clear about the business purpose, you are all set to establish it. Remember, business purpose is altogether a different thing from your business’s vision, mission or objectives. If you are making a not-for-profit business then your purpose is to serve the society but if you are planning to run a profitable business- which I am assuming you are- then your business purpose is to make as many customers as you can to increase  your top line growth and to manage your expenses which enable you achieve a handsome bottom line profit. In simpler words, your business purpose is to make maximum profit out of your business. Now that you are clear on the purpose of your business, let’s get you some profit!

2. Create Business Goals

Business goals are indispensable to company formation or success. Now, when you have defined that your business purpose is to make maximum profit, the next step is to create business goals against this purpose. All your goals must revolve around your business purpose. Your goals must be designed in a way that can provide you with a clear insight of your future standing in the relevant industry, returns on borrowed capital, your cost and expenses. In order to get a simplified understating of business goals, you can divide your goals into three categories:

  • Core Business Goals: Core business goals are set in a way that they can contribute to your business vision. However, it is equally important that even the core business goals should be aligned with your business purpose i.e. to maximize profit. Your company’s success and thus profitability directly depend on two main factors. Firstly, how satisfied your customers are and secondly the satisfaction of your employees. In the later section, I’ll explain how to set actions against these goals.
  • Income Generating Goals: Income Generating Goals are specifically created to define the plans which can generate maximum income with an increasing rate in a specific period of time.
  • Expenditure Regulating Goals: Expenditure Generating Goals are the goals which are formed to calculate expenses and how to manage expenses while expanding the business which could yield maximum profit.

3. Action Plans for Each Goal

Once you have created your business goals with the main purpose of earning maximum profit in your mind, the next step is to create action plans against each goal. An action plan is a practical application of goals. They must be realistic, practical and assist in achieving all goals in a definite period of time.   

All your goals and action plans can go for every type of business in the most practical manner; you can specify them according to your business nature and industry type. 

4. Gross Profit Margin

By now, you have formulated a clear strategy of how to form a company or improve your existing one but now the question arises “How do you calculate your profit?” There are varieties of ways in which you can calculate your business profit. Internet is full of these ways but when you go after these methods you end up in finding yourself in no man’s land because of the complexity of these financial terms. Say NO to this confusion as I am going to suggest a simpler way to calculate profit. You can do it yourself without hiring any financial expert.

Calculating profit margin is the most appropriate way not only to determine your business profitability but also to keep your business on a track of consistent profitability. Profit alone cannot give you the whole picture. There is no denying the fact that it is important to calculate your profits but profit margin determines the success of your business more accurately with the passage of time. For example, your profit for the year 2015 is 5 million and your profit margin is 10% and the other company’s profit is also 5 million with the profit margin of 20% then it means you are way behind in controlling your expenses. Gross Profit Margin gives you better insight for your potential area of improvement. Profit margin tells you whether business is generating  profit for you or not. It is calculated in percentage. There are two main types of margin i.e. Gross Profit Margin and Net Profit Margin. When we talk about profit margin generally it is gross profit margin.

To calculate Gross Profit Margin, we first need to calculate Gross Profit.

Gross Profit  =  Sales Revenue-Cost of Goods Sold

Suppose if Sales Revenue for the year 2016 is 500,000 and Cost of Goods Sold is 300,000 then your Gross Profit would be:

500,000-400,000 = 100,000

Now when you have a gross profit, you can calculate the gross profit margin.

Gross Profit Margin=(Gross Profit)/(Sales Revenue)  ×100

Again using our example,

Gross Profit Margin=100,000/500,000  ×100 = 20 %

Hence, your gross profit margin will be 20 %

5. Increasing Gross Margin Profit

Finally, you have calculated your Gross Profit Margin. But in this example, I have presented a very delightful picture by mentioning gross profit margin around 20%. In reality, this is not what you will always get. In order to keep on increasing your gross profit and gross profit margin you must consider the following:

  • Monitor Marginal Contribution

You need to monitor your marginal contribution to profits. It helps you calculate and thus control the cost of each product. This concept is used to determine the cost of each product and how to induce new business units while maintaining or reducing cost per product.

For example, the cost of per product is $5 when your produce 100 products annually. If you add one more machine and start producing 105 products then your each product cost will rise to around $8 as your production is not aligned with the demand. So, you should install new equipment when the demand of your product is around 180 which will bring back your cost to $5. This is how monitoring a marginal contribution can regulate your business profitability.

  • Increase Business Sales Revenue

Profit Margin directly depends on your sales revenue, so your maximum efforts must be exerted to increase your business sales revenue. To increase sales revenue you must have to articulate a profit-oriented strategy before setting your targets and planning your pricing. Here are the few common ways to increase sales revenue:

  • Increase your Customers: Every business owner wants to increase customers who buy his/her products or services. That’s what we hear time and again from everyone who does business. If you want to increase your no of customers, you must:
  1. Retain your old customers by giving them discounts and benefits. Extra value-oriented services will not only help retaining customers but also assist in increasing no of transactions per customer.
  2. Attract new customers by following different marketing strategies. Try to make your product known to as many people as you can. These days, social media is a less costly medium to market your product and boost your sales.
  • Raise Prices: Once you establish your product and people start trusting your product, raise your prices while trying to reduce or even maintain the overall cost. Raising prices requires some market research to know whether your customers are ready to pay that much price. It all depends on how you create the value of your product in the eyes of customers.

In epitome, if you want to increase the profitability of your business you must first understand gross profit margin and its implications. If profit maximization is your basic purpose, it is mandatory that you must develop a proper understanding of gross profit margin. Your proper understanding of gross profit margin will let you increase your business sales revenue and minimize cost by monitoring your marginal cost.