As an entrepreneur who is out to build a legacy, you can probably sell products in your sleep. Literally. If you have set up an inflow of passive income, your bank account grows overnight. Instead of “rise and grind,” it’s more like “sleep and reap.”
But being a successful business owner has always been about much more than exchanging goods or services for money. You’ve got to ensure that your expenses don’t eat too much into your profits. When your profit margin ratio is high, so is your business’s level of opportunity. On the flip side, a lower-than-average profit margin ratio can spell trouble.
Understanding the Importance of the Profit Margin Formula
Knowing how to calculate profit margin is an essential arrow in your quiver when it comes to managing your business. The formulas you’ll use to measure and track your revenue, expenses, and other important components are called key performance indicators (KPIs).
The effective use of KPIs is similar to what a healthcare professional does for you at a biometric screening. Let’s say you were to go to meet with your doctor every January for a comprehensive physical examination. The screening might include things like body mass index (BMI), blood cholesterol levels, and a blood pressure measurement.
These metrics could be considered your body’s KPIs and the doctor would assess them and then alert you of any issues. If your blood pressure were 140/90, for example, rather than it just being a simple number, the level would indicate health issues that might require treatment or medication.
Likewise, KPIs provide insights into your business’s health and performance. And just as abnormally low blood pressure can have cascading impacts on other areas of your health, a low profit margin will hurt diverse parts of your business and ultimately leave you struggling to succeed.
But the truth is that most of us don’t like going to the doctor. And many entrepreneurs take a similar approach to KPIs such as profit margin. As business owners, they have grand ambitions. But they don’t want to bother with the nuts and bolts that are required to transport them there. Ignorance is never bliss in these situations. And what you don’t know can inevitably lead to your downfall.
As Ivan Kreimer explains:
When you first start your online business, it’s easy to fall for lofty goals. You want to launch several products. You want to expand to different international markets. You want to sell thorough solutions at low prices. These goals, however, can overlook the financial infrastructure required. It’s great to dream, but reality will come crashing down very quickly. You need to have an air-tight budget that defines the natural constraints of your business so you can realistically grow in the shape that your resources allow you to. You need to be aware of your limits, even though it’s not fun. This pragmatic mentality will help you grow your business on solid ground.
By consistently tracking your KPIs, you’ll gain better control of your business’s daily functions and also have more control over its destiny. Before long, the KPIs will become like a second language. It will be easier to evaluate them and derive insights.
Here are 11 KPIs you should think about incorporating:
- Gross profit margin
- Net profit margin
- Net income
- Quick ratio
- Budget vs. actual
- Operating cash flow
- Average customer acquisition cost
- Funnel flow
- Customer retention
- Churn rate
- Year-to-date sales growth
Perhaps your business is structured in a way that makes one or two of these KPIs less relevant. But it’s practically guaranteed that you’ll want to make the profit margin related KPIs a top priority.
How to Calculate Profit Margin
What is a good profit margin? That answer totally depends on your industry. It’s important to learn the average profit margin for a business such as your own, then use that as your baseline. Of course, that information won’t do you any good unless you know how to calculate gross profit margin and how to calculate net profit margin.
Net Profit Margin Formula
Using the net profit margin formula, you can shine a light on your business’s revenue and expenses. Because you could have record-setting revenue, but the impact would be minimal if it were accompanied by equally high expenses.
Use this formula to reveal your net profit margin:
(net profit ÷ net revenue) x 100 = net profit margin
The ratio you get from this formula tells you the percentage of profit your company brings in from the total revenue. Higher percentages mean that your operations are humming along and you’re retaining a good portion of every dollar you bring in from sales. A lower percentage suggests there are inefficiencies that are hurting your bottom line.
Gross Profit Margin Formula
To get a glimpse into the broader range of your business, you’ll want to use the gross profit margin formula. This tool helps you gauge the effectiveness of things such as pricing strategies, production processes, and manufacturing efforts.
Use this formula to reveal your gross profit margin:
gross profit ÷ total revenue = gross profit margin
This KPI reveals how much of your sales revenue is left after you subtract the cost of goods sold. You’ll use portions of the remaining money for expenses such as research, development, administration, salaries, and marketing.
Operating Profit Margin Ratio
Leverage this KPI to measure your profit on each sales dollar after taking care of costs such as materials and wages. Be aware that expenses such as tax and interest aren’t included in this metric.
Use this formula to reveal your gross profit margin:
(operating income ÷ net sales) × 100 = operating profit margin ratio
The healthiest companies have a steadily rising operating profit margin ratio, punctuated by periods of plateaus and declines. When the declines become more common and pronounced, it becomes impossible to thrive.
With all 3 of these formulas, the key to knowing what is a good profit margin comes down to understanding the averages in your industry. Here’s a quick snapshot at some businesses with high profit margins:
- Business courses
- Bookkeeping and accounting
- Business consulting
- Marketing copywriter
- Graphic design
- Social media management
- Food trucks
- IT support
- Apps for children
- Language courses
Conversely, businesses within the following industries typically have much lower profit margins:
- Grocery stores
- Medical equipment manufacturing
- Real estate services
- Recreation services
- Retirement facilities
- Assisted living facilities
- Car dealerships
It’s not necessarily a problem to operate within an industry that has profit margins on the low end. You just need to conduct the research to know the average profit margins of your competitors. Using this baseline, you can then gauge the effectiveness of your operations and accurately create growth strategies.
Effectively Using Profit Margins and Other KPIs
Every business needs goals to guide its growth. And those goals are executed through various tactics and strategies. But throwing around important-sounding words like “tactics” and “strategies” is pointless without the data that gives them intelligence.
This is where your KPIs come into play.
The learnings you gain from your profit margin formulas and other KPIs should serve as your North Star. Sure, you can make plans without them. But it’s a lot easier to miss your destination when you’re operating on hunches.
Some businesses view KPIs as a once-a-year event, comparable to the annual company picnic in the summer. Nothing could be further from the truth. You need to proactively check these various metrics so that you can anticipate issues and make necessary adjustments.
Fortune doesn’t just favor the bold—it favors those who are informed and prepared. Once you’ve gathered the right data, go ahead and be as bold as you want. Take that moonshot. Just realize that no astronauts have ever attempted to reach the moon without ample training and years of research.
When your business is in its early months, there will be fewer metrics to think about. But don’t get too comfortable with your limited collection of KPIs. If you’re a growth-minded entrepreneur, there’s going to be expansion ahead.
“An often overlooked and scary-looking part for many entrepreneurs, finances are the lifeblood that make your business run smoothly,” insists Ivan Kreimer. “You want to make sure that as your business grows, your finances grow with it.”
Because you’ll be adding new KPIs along the way, it’s important to know how to choose the right ones. The profit margin formulas are non-negotiable, but what about more obscure choices such as sales quotes provided, win rate by opportunity value, or impression weighted quality score?
Here’s a test to consider: Does this KPI relate to one of my business’s strengths, one of my business’s weaknesses, or where I want my business to go? If you answer “yes” to one of these questions, the KPI is a strong contender for your financial tracking. If you answer “yes” to 2 of the questions, then there’s nothing left to debate. You’ve identified a crucial KPI that will help make your goals more actionable and measurable.
Don’t Leave Your Business Plan in the Dust
As you use data and experience to guide the evolution of your business, it will naturally deviate in some ways from your business plan. This doesn’t invalidate the projections and goals you outlined in that important document. It simply means that you’re creating a dynamic business that is more beholden to data and customers than to the initial plan.
This is a mature and sophisticated way to approach your business. And the payoff can be substantial.
Just be sure to make your business plan a living document that evolves right along with your business. Rather than stuffing it away in a filing cabinet, you should use it in conjunction with your KPIs. When data confirms aspects of your plan, you can proceed with extra boldness. When new information prompts changes, make the necessary updates to your plan.
There should be a symbiotic relationship between your business plan and the metrics you’re monitoring. Not only will this approach keep your business adaptable, but it’ll prevent the embarrassing situation that sometimes arises when an entrepreneur who has neglected their business plan seeks financing. Inevitably, the lender will ask to review the business plan as part of their evaluation process. Unfortunately, that dusty, old document will hardly resemble what the business has become and where it’s headed.
As you can imagine, these kinds of disconnects aren’t viewed favorably by lenders. They’re looking for business owners who are organized and focused.
When you make your profit margins and other KPIs part of your leadership style, nearly every aspect of your professional life gets better. You’ll know where you came from, where you currently are, and where you’re going.
Of course, running a successful business takes more than KPIs. That’s why we’ve assembled some of the top entrepreneurs from various industries to share their proven strategies.
Within our library of free courses, you’ll learn how to identify the products that will become your top-sellers, how to negotiate better deals, how to boost your profits, how to attract new Instagram followers, how to enhance your marketing efforts on YouTube, and how to more effectively target your advertising efforts.
Most importantly, you should check out the Finance for Founders course from Alexa Von Tobel. You’ll learn how to keep more of the money you earn, managing your finances in a way that takes most entrepreneurs decades to master.