As a small business owner, one of your core responsibilities is to earn a profit. Whether you plan on reinvesting money into your company, donating a portion to charity, or starting yet another new venture to expand your empire, earning a profit is necessary to keep your doors open and your business moving forward.
And the way to measure profitability? Calculating your profit margin.
A good profit margin for a small business is 7% to 10%, with 5% considered low and 20% high.
But what, exactly, is a profit margin and why is having a solid one so important? And what can you do to boost your profit margin—and drive more profit for your business? Let's get into all that and more.
What Is a Profit Margin?
A profit margin is a ratio that compares your profits to your revenue, operating expenses, and other points of data to help determine the financial health of your business—and is typically represented as a percentage.
For example, a small business with a 20% profit margin earns a profit of 20 cents for each dollar of revenue.
Large corporations and publicly traded companies are generally required to report financial statements, including profit margins, on an annual and quarterly basis. On the flip side, if you run a small business, you typically have much more leeway.
This means you can compute this profitability ratio as frequently—or infrequently—as you like. One catch? If your business requires funding from lenders or investors, you might have to report your profit margins on a regular schedule—for example, every month—to keep them informed of your company’s growth and current profitability.
Bonus tip: Improve your margins by using Hourly, which ensures you get accurate workers’ compensation premiums down to the penny. That way, you can avoid getting slammed with a huge audit bill. And running payroll is as quick as pressing a button.
Average Profit Margin by Industry
As a small business owner, one way to determine the quality of your profit margin is to compare your margin to other businesses in your industry.
In 2023, the average net margin across all industries was 8.89%, and the average gross margin was 36.28%. Average profit margins by industry are as follows:
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Factors That Impact Your Profit Margin
Even though you might know your industry standard, there’s no one-size-fits-all answer for what makes a good margin. What’s considered a “good” profit margin can—and will—vary based on a wide variety of factors.
If you’re looking to determine if your business’ overall profitability falls under the “good” umbrella, some factors you’ll want to consider include:
- The size of your business: As a business expands, its margins might fall—even as revenue grows. This is common after hiring more employees, introducing new products or services, or purchasing new equipment/office space. For example, a solo entrepreneur who works from home might have a high profit margin compared to a small business owner that employs dozens of workers over multiple locations.
- Your location: Costs like rent, taxes, and other overhead can vary depending on where your company is located. This means your profit margins might differ from similar companies in other cities and states. For example, a restaurant in California might have a lower profit margin than one in Alabama due to higher payroll costs and rent—even if the restaurant in California has higher revenue.
- Your growth: Investing in your business—by buying new equipment, hiring more employees, or expanding your physical footprint—can eat into your margins (even though the change is generally temporary). This means your margins might be tighter than similar businesses that didn’t make these decisions in a given time period. For example, a construction company that purchases new equipment and tools during a quarter might have lower margins than a competitor that hasn’t expanded during the same time period.
- Your industry: You may have already noticed there is a pretty wide range of profit margins in the chart above, but it’s worth reiterating that some small businesses—and different industries in general—are inherently low-margin. This is typical of businesses with significant overhead, low markup, or high competition, like retailers and grocery stores. On the other hand, other businesses—those with limited overhead expenses, high-dollar products, or service-oriented offers—might have higher margins, like bookkeepers or software-as-a-service (SaaS) providers.
Different Types of Profit Margins
There are three main types of profit margins, with each type being useful for analyzing different aspects of your revenue. These include:
Net Profit Margin
The net profit margin (also called the net margin or NPM) measures your net income as a percentage of your revenue.
In other words, your net profit margin is the ratio of your net income to revenue. This is typically represented as a percent but can also be calculated in decimal form.
Generally, your NPM is the most important type of profit margin. The reason? It reveals how much profit your business generates for every dollar of sales after subtracting its total expenses.
By taking account of all of the expenses involved in making a product or providing a service, NPM gives you the most comprehensive overview of your company’s profitability. This can help you make better decisions, know when to apply for funding, and plan for the future.
To calculate your net profit margin:
- Subtract the cost of goods sold (or COGS, which consists of labor costs and the cost of materials to produce a product), total expenses (business expenses, operating expenses, overhead costs, and other expenses), interest you owe on debt, and taxes payable from your total revenue OR refer to your net income (found on the bottom line of your income statement).
- Divide by your total revenue.
- Multiply the result by 100 to create a percentage.
The net profit margin formula looks like this:
(Total revenue - Cost of goods sold - Total expenses - Interest - Taxes / Total revenue) x 100
Example
What does the net profit margin formula look like in action? Let’s use some example figures to demonstrate:
- Revenue: $2,000,000
- COGS: $500,000
- Total expenses: $1,000,000
- Interest: $100,000
- Taxes: $50,000
With these figures, the calculation for determining your net profit is:
($2,000,000 - $500,000 - $1,000,000 - $100,000 - $50,000 / $2,000,000) x 100
= 17.5%
In other words, you would make a profit of 17.5 cents for every dollar of revenue.
Gross Profit Margin
Gross profit margin (also called the gross margin or GPM) is the amount of gross profit you generate as a percentage of your revenue. Compared to net margin, gross margin deducts a lot fewer expenses from the equation. While you still deduct the cost of goods sold to get this ratio, you don’t deduct business and operating expenses—as well as other kinds of expenses.
You should expect your gross margin to remain consistent if your business is financially healthy. It signals you’re able to control costs and sell your product at a predictable rate and price.
That said, major changes to your GPM can signal issues with your company—like increased costs in manufacturing your products or providing your services—which makes GPM a good metric to track over time.
But that’s not all. Determining your GPM can help you measure the profitability of your products/services compared to the cost it takes to manufacture or provide them, helping you adjust your pricing strategy or cut low-performing items or services.
To calculate your gross profit margin:
- Subtract your cost of goods sold from your revenue.
- Divide by your revenue (a.k.a. net sales).
- Multiply the result by 100 to create a percentage.
The gross profit margin formula looks like this:
(Revenue - Cost of goods sold / Revenue) x 100
Example
For example, let’s say you generated $2,000,000 in revenue and have a COGS of $500,000. The calculation would look like this:
($2,000,000 - $500,000 / $2,000,000) x 100
= 75%
With these figures, you would have a gross profit margin of 75%.
Operating Profit Margin
The operating profit margin (also called the operating margin, OPM, or return on sales) measures the profit you make per dollar of sales after subtracting your costs of production (like material and labor costs) and other expenses (like general and administrative costs)—not counting interest or tax.
Where net profit measures your profits after accounting for all of your costs and gross profit measures your earnings after deducting production costs, your operating margin represents the profits you earn for each sale after accounting for variable costs—what it costs to actually run your business.
Generally, operating margins should be stable if your business is generating an efficient and consistent revenue from your core operations—i.e., the products you sell or services you provide.
A high OPM means your business is mostly (or entirely) generating revenue from its primary sales—whether you sell products or offer services—and not from other incomes, like investments.
In other words, a high OPM means your business is performing well at its core purpose—for example, a plumbing company making the majority of its revenue through plumbing services vs. income from properties it might rent out (or sublet).
Significant fluctuations can mean your business isn’t efficient or lacks proper management. This can make it difficult to take out a loan or attract investors.
To calculate your operating profit margin:
- Determine your earnings (or operating income) before interest and taxes (EBIT) by subtracting the costs and other expenses (excluding interest and taxes) from your revenue.
- Divide by your revenue.
- Multiply the result by 100 to create a percentage.
The operating margin formula looks like:
(Operating income: Revenue - COGS - EBIT / Revenue) x 100
Example
For example, let’s say you generated a revenue of $2,000,000, have a COGS of $1,000,000, and total operating expenses (excluding interest and taxes) of $500,000. Your calculation would look like this:
($2,000,000 - $1,000,000 - $500,000 / $2,000,000) x 100
= 25%
This means your operating margin is 25%.
What Impacts the Profit Margin of a Business?
It’s generally beneficial to maintain (or increase) your profit margins. After all, earning a profit is necessary to grow your small business and accomplish your goals. But profit margins can and do fluctuate based on factors in and out of your control, including:
Labor Costs
The higher your labor costs, the lower your profits. Issues like high turnover or overstaffing your workforce can cut into your profits and decrease your margins, making it important to manage how much you spend on labor—and avoid overspending.
Production Costs
Any goods you produce or services you provide incur a production cost. These expenses include direct costs that are tied to specific expenses, like raw materials, equipment, supplies, labor, and overhead expenses—or, in other words, any costs that go into making a product or selling a service.
Production costs can be fixed (like a monthly subscription fee for access to an important app) or variable, like the cost of shipping.
In other words, money spent producing goods or providing services has a direct impact on your profit margin—the higher your production costs, the lower your profits.
Pricing
The price of your products and services—what they cost your customers and clients—can eat into (or increase) your profit margin. But how, exactly?
That depends on your pricing strategy. Your markup—what you add to the prices of your products/services on top of the product costs and other expenses—needs to be high enough to turn a profit without pricing out your customers.
For example, a low markup can limit your margins while making you more competitive in the marketplace. In contrast, increasing your markup can result in high profit margins—but potentially make it more difficult to sell your products or attract buyers.
This means you need to find a balance by comparing your pricing to your profit margins—while also taking your competition, customers, and the economy into account.
Why Is a Good Profit Margin So Important?
You know what profit margin is (and how to calculate it). Now, let’s go into why maintaining a decent profit margin is so important.
There are a number of reasons why it’s important to achieve—and maintain—a good margin of profit, including:
- It indicates financial health and stability: A good margin indicates that your company is healthy, stable, and growing. This can help you secure capital, take out a loan, or attract investors.
- It helps measure your earnings: By calculating your profit margin, you can get a better picture of your company’s profitability beyond its total sales revenue. This can help you determine how much money is available after accounting for operating costs and other expenses, helping you figure out how to invest back into your business without compromising your cash flow or requiring additional outside funding.
- It can help you plan for growth: Growing your business can mean hiring more employees, investing in better equipment, or buying more office space. Without enough profit, it can be difficult to fund business growth. A decent profit margin can help you set milestones to plan—and eventually pay for—business expansion.
- It can identify issues and points of failure: A low profit margin (relative to industry averages) can indicate issues with your business, like paying too much for materials or overstaffing your workforce. On the flip side, a healthy profit margin can reveal that things are running smoothly.
- It can help you recognize seasonal patterns and performance trends: Profit margins can fluctuate over time, so tracking yours during different sales seasons can help you plan for trends.
Three Tips for Boosting Your Profit Margin
Clearly, prioritizing your profit margin is a must—as the higher your margins, the higher your profits. But what steps can you take to boost your small business profit margin—and go from average to good to stellar on the “how good is your profit margin?” scale?
1. Source More Affordable Materials
The more expensive it is for you to produce your products or provide your services, the lower your margins. For example, let’s say you operate a bakery. To bake a cake, you need to spend $20 on ingredients alone, with a labor cost (and other expenses) of $12. If you sold the cake for $35, your profit for the cake alone would be $3 (or a net margin of 8.57%).
To increase your profits, you could negotiate with your vendor for a better price on ingredients or source more affordable ingredients from another supplier (though make sure they’re of a similar quality to avoid upsetting your customers and losing sales).
2. Increase Prices
Raising your prices can increase your cash flow, resulting in more revenue. This is especially helpful if your expenses (like utility costs, rent, or insurance premiums) increase through no fault of your own. By raising your prices/rates, you generate higher sales revenue without increasing your expenses, resulting in a higher margin.
However, you need to be careful that you don’t price yourself out of the market—or make your competition look more appealing. Though customers understand that prices need to increase from time to time, the cost of your products/services should still be reasonable; otherwise, you risk losing business—and actually lowering your revenue and margin.
3. Improve Efficiency
Generally, improving efficiency means cutting costs—and when you cut costs, you can increase your profit margin.
Some ways to improve efficiency in your business (and improve profit margin in the process!) include:
- Make sure you’re not overstaffed
- Reduce waste by recycling materials or using less packaging
- Lower fulfillment costs by negotiating better shipping rates or reducing the weight/dimensions of your products
- Manage inventory better by cutting underperforming products/services, keeping a smaller backstock, or adding high-margin products to your inventory
- Buy equipment or use tools that reduce labor costs, like payroll processing tools that lower the time and money it takes to run payroll and other administrative tasks
Know Where You Stand So You Can Grow
A business’s profit margin is one of the key metrics for determining its profitability. By focusing on achieving and maintaining a healthy profit margin—and using that information to make strategic choices—you can keep your business strong, and even grow.
