It is the goal of every business - to be profitable. But, how do you truly know the profitability of your small business?
With incoming revenue and outgoing expenses, it is easy to get lost in the numbers.
While no single metric should be used to determine profitability of a business, small business accountants can use net profit margin to gain an insight into the success of your business.
Let’s discuss the importance of this metric and review the differing factors that contribute to the calculation of net profit margin between product-based businesses and service-based businesses.
We’ll also provide insight on maintaining realistic expectations for net profit margin for not only your business category and industry, but the phases that your business will go through.
Read on for suggestions for determining - and improving - your service based business’s net profit margin.
GROSS PROFIT MARGIN VS. NET PROFIT MARGIN
Conventionally indicated as percentages, the two main types of profit margin are gross profit margin and net profit margin. While both are important figures for small business owners to know, it is net profit margin that is vital for evaluating the profitability of the business as a whole.
Let’s brush up on the important terms and formulas that determine gross profit margin and net profit margin before discussing the factors that may contribute to the high or low margins of your service-based business.
Revenue is the gross income your business receives from the sale of products and/or services before deducting expenses. Some people refer to this as the “top line revenue” or “gross billings” or “gross sales revenue.” Revenue is usually reported monthly, quarterly or on an annual basis.
COST OF GOODS SOLD
Whether it is the cost of manufacturing a product or the cost of time spent assisting a client, these are the total costs that are directly attributed to the product and/or service sold by your company.
Gross Profit is your company’s revenue minus the cost of the goods sold (COGS). In other words, it is how much your business keeps after accounting for the cost of the product or service that was sold.
This figure is important for determining the profitability of a particular product or service, but that is the extent of what this number tells us.
Formula: Revenue - COGS = Gross Profit
Example: $500,000 - $200,000 = $300,000
GROSS PROFIT MARGIN
To calculate gross profit margin, also known as gross margin, simply divide gross profit by revenue. This will provide you with the ratio of gross profit compared to your total revenue.
Formula: Gross Profit / Revenue - Gross Profit Margin
Example: $300,000 / $500,000 = $0.60 or 60%
What this tells us is that for every $1 of product sold, this example business earned 60 cents.
RELATED: Check out our quick video explaining this calculation.
Sounds great, right? However, this is the not the only number to focus on when trying to make sure your business is profitable.
Instead of focusing solely on the cost of the goods sold, net profit is equal to your company’s total revenue minus the total business expenses. Net Profit is how much your business gets to keep after accounting for all your business expenses.
Formula: Revenue - COGS - Total Operating Expenses - Interest Expense - Taxes = Net Profit
Example: $500,000 - $200,000 - $200,000 - $5,000 - $5,000 = $90,000
NET PROFIT MARGIN
We will calculate this formula the same way we calculated the gross profit margin by dividing net profit by revenue.
Formula: Net Profit / Revenue = Net Profit Margin
Example: $90,000 / $500,000 = $0.18 or 18%
This tells us that for every dollar the business earns, it profits 18 cents.
As you can see, this tells a much different story than the high percentage of the gross profit margin.
Let’s explore why this metric holds so much importance for your business.
THE IMPORTANCE OF NET PROFIT MARGIN
While you should keep in mind that this sole metric cannot determine how your business is doing, financial experts often refer to net profit margin as the business’s “bottom line” for a reason.
Providing insight into the financial health and stability of the business, net profit margin is critical for lenders to assess the likelihood of defaulting on a loan and is used by investors to determine whether or not they are willing to invest in your business.
Regardless of the size of the company, this metric is a great way to gauge yourself against competitors. Comparing your net profit margin to other peer businesses within your same industry and category allows you to see if you are doing better or worse than your competition.
Simply stated, having a positive net profit margin shows that your business is profitable.
FACTORS: PRODUCT-BASED INDUSTRIES VS. SERVICE-BASED INDUSTRIES
Margins vary greatly by sector and industry. It is important to keep in mind that net profit margin only measures how much money is earned per each dollar of sales and does not determine how much money your business has the potential to make.
In addition to a very wide range of industry types, several factors decide what adds to - or takes away from - a business’s net profit margin.
Let’s take a few moments to go through a couple examples of factors that determine net profit margin of product-based businesses before getting into the different possible factors of your service-based business.
With net profit margins ranging from 1-3%, grocery stores and supermarkets provide the perfect example of a low-margin product-based industry.
This is due to several factors including the relative low barrier of entry into the industry. A low barrier to entry typically leads to a large amount of competitors, as well as the need to keep an expansive inventory that is constantly turned over.
To make up for these factors, grocery stores must have a strong customer volume and must sell substantial quantities of their products in order to keep the doors open for business.
On the other hand, the growing pharmaceutical industry enjoys much larger net profit margins, with the major manufacturers averaging around 18%.
A couple of the reasons behind this industry’s higher net profit margins include high barriers of entry due to enormous risks and costs associated with research and development as well as compliance requirements in order to get new and effective medicines to market. The pharmaceutical industry also has to move quickly because there is a relatively short amount of time until generic versions of the drugs are able to be sold and undercuts sales.
While the aforementioned reasons make sense for industries selling tangible products, the factors in figuring net profit margin for intangible, service-based businesses can be a little more difficult to determine.
Whether the service is repairing computers, packing and moving for homeowners and renters, tutoring or auditing, there are several factors that need to be considered for these types of business.
- Direct Costs
Direct Costs are the costs that can be fully attributed to the production of a service.
In product-based industries, these costs could include material and transportation. For service-based industries, you’re looking at costs such as the salary of a supervisor who oversaw a specific project for a set amount of time. It could also be a sales commission paid in association with a specific project.
If ABC Company is designing a custom computer program for a customer for their own internal use, then the costs would be assigned to the customer as a direct cost.
- Indirect Costs
Moving beyond direct costs attributed to a particular service, Indirect Costs are the common day-to-day costs of doing business.
Examples of indirect costs include typical overhead costs like rent and utilities, but can also include cleaning supplies, computers, cell phones, costs of technology and office furniture.
There are also several indirect costs which can be associated with employees. Substantial costs accompany health insurance and other benefits, as well as employee training.
Administrative costs are integral to the daily operation and are therefore considered indirect costs.
- Time Costs
You have heard it said, “Time is money.” Collecting and monitoring data to help you figure out just how much time is necessary for a service or project makes projecting your project costs much easier. Time-tracking programs enable you to monitor the productivity of employees and determine how long your company requires to complete certain services.
- Employee Salaries
A marketing director who has been in a senior position within your firm for the last seven years will not be on the same end of the salary spectrum as a young graphic designer who is still getting settled in. For the purpose of accounting for the indirect costs of their salaries, calculating an average hourly rate is beneficial. Your small business accountant can assist you with this calculation.
While a certain level of marketing is vital to your business’ success, it is important not to get carried away. Whether your marketing strategies are handled mostly by your social media manager or if you are running major SEO campaigns, your net profit margin can take a serious hit from advertising costs.
While small business owners should pay close attention to growing their net profit margin as much as they can, it is important to maintain realistic expectations within your category and industry. Very successful businesses may have lower net profit margins than you might assume.
In addition, depending on the phase that your business is currently in, your net profit margin may be much lower than you expect. During periods of growth where profits are being invested back into the company, this expansion and growth will not be reflected in the net profit margin.
As your business begins to mature, keep in mind that your net profit margin may begin to decrease. This is due to the added expenses that accompany the growth of any company, an example being the hiring more staff members.
WAYS TO IMPROVE YOUR NET PROFIT MARGIN
Since net profit margin is the end result of an all encompassing formula - revenue, cost of goods sold, total operating expenses (direct costs, indirect costs, marketing, etc.), interest expenses and taxes - small business owners should remember that to change one aspect of this formula will likely impact other aspects of the formula too.
For example, increasing your prices may seem like an obvious way to increase your revenue, but an increase in prices may have an impact on your current and future client base. How would they respond to an increase? In an effort to make more money, increasing prices could potentially result in spending that amount or more to gain lost business.
As mentioned previously, advertising costs can take a chunk out of your small business’s net profit margin if you’re not careful. Consider referral programs as a cost-effective, and just generally overall effective way of gaining new customers. After all, there is no better marketing strategy than old fashioned word-of-mouth. With social media, you can be more creative than ever.
Incorporate social gifting by providing clients with referral codes that they may send to their friends for free trials of your service. Offer small incentives for clients who refer family or friends, and hold occasional contests for a prize to the client who refers the most. Brainstorm and think of ways that your clients can have fun with it.
A good place to look when trying to weed out unnecessary expenses is your administrative costs. Because they do not directly affect the quality of the service your business provides, it is a good idea to frequently evaluate them to see where these costs may be reduced.
Interest Expenses and Taxes
Review your interest rates for business credit cards and loans. If feasible, it may be a good idea to pay back these debts as soon as you can to save you from high interest rates.
As far as taxes, this is one area where we all feel like we are throwing away money. Your small business accounting service provider can help you whittle down your federal, state and local taxes as much as possible through the form of incentives, additional deductions and/or other possible measures.
We hope this information helps you determine not only net profit margin for your service-based business, but provides ways to help you work to increase it. By staying attentive to this metric as your company grows and matures, you will ensure your business continues to stay profitable.
Be sure to check out our online bookkeeping services and accounting resources for more information to help you manage your business needs.