Profits vs. Profitability: Why Profit Margins are Important

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In addition to pursuing your passion, making money is the most-popular reason for starting a business. Therefore, all business owners need to pay attention to their profits. Calculating profit is easy. All that is required to determine your profit is to take your total revenue and subtract your total expenses. However, simply looking at profits can be deceiving because profits do not necessarily add up to profitability. The best way to illustrate this is through a simple example.

In a year, Company A generates $1,000,000 in revenue while Company B earns $500,000. Correspondingly, they have $900,000 and $400,000 in expenses. As a result, both companies earned the same amount of profit: $100,000. Since they both earned the same amount of profit, does that mean that one was just as profitable as the other? The answer is no. Company A had to spend more money than Company B in order to generate the same dollar amount of profit. This concept, which is key to profit margins, is expressed as a percentage and is used to measure a business’s overall profitability. In our example, the profit margin of Company A is derived by taking the profit and dividing it by the revenue ($100,000/$1,000,000) and is equal to 10 percent. For Company B, the profit margin is equal to 20 percent ($100,000/$500,000).

Profit margins are the most definitive method for seeing how successful a business’s sales efforts are relative to its expenses. If a business’s profit margin percentage is high, it means that the business retains more money after all expenses have been paid. If the profit margin percentage is low, it could mean that the business is paying more in expenses than it can generate in revenue.

Monitoring profit margins helps a business owner to know the overall financial health of the business, be better able to optimize profits, and grow their company.

While there are several types of profit margins that a business can calculate, we will focus on the two margin types that most businesses typically use. The first is Gross Profit Margin and is the simplest of the two to calculate. The Gross Profit Margin represents gross profit (total revenue minus cost of goods sold) as a percentage of revenue:

  • Gross Profit Margin = (Gross Profit/Revenue) x 100

Your company’s profits might be increasing, but if expenses are also on the rise, your gross profit margin could be declining. If you only look at gross profit, you won’t notice the decrease.

The second margin type is Net Profit Margin. The Net Profit Margin expresses net profit (total revenue minus cost of goods sold and operating expenses) as a percentage of revenue:

  • Net Profit Margin = (Net Income/Revenue) x 100

The Net Profit Margin can lend insight into operational concerns or expense issues. A lower ratio can show that too much is being spent on expenses while generating little profit, while a higher ratio can show a greater ability to turn revenue into profits.

When profits decline or expenses increase, the profit margin will go down. There are a variety of reasons why this can happen. A decline in profits can be the result of a changing economy, which can impact everything from consumer behavior to interest rates to the cost of raw materials, labor, and production. An outdated business model, a shift in your customer base, the introduction of new technology that changes the market, or something as simple as changes in accounting procedures all can affect your revenue versus profit ratio, causing your profit margins to decline.

Profits vs. Profitability Example

If your company’s profit margin percentages are low, there are two ways to enhance profitability: increase your prices or cut your expenses. While your first thought might be to increase prices, proceed with caution and make sure to do your research. Disappointing profits alone are not enough of a reason to raise prices. When you raise prices, there is the risk of overcharging, driving away your customer base, and diminishing sales. You need to analyze your company’s job costing methods as well as your cost of goods sold to make sure that you are charging a fair price for your services. If you realize that your prices are too low, then you should consider strategically increasing the price of your products or services.

The second way to increase profit margin is by reducing your expenses. This includes both direct and indirect costs. Direct costs are expenses that directly go into producing your company’s goods or providing your company’s services, while indirect costs are those general business expenses that keep your company operating. Carefully review all your expenses to see which ones are essential and which ones could be reduced or eliminated altogether. Evaluate your business processes to see where time is wasted and consider automating certain tasks that your business carries out on a regular basis. Look for vendors that will provide materials and supplies to you for a lower price or will negotiate better discounts or payment terms. These are just a few examples of cost-cutting measures that should lead to a higher profit margin for your business.

When it comes to improving profitability, managing and increasing your company’s profit margins is key. Knowing your company’s profit margins can help you make decisions that will allow your business to be financially successful and contribute to its longevity.

Dana Rogers is controller for the National Wood Flooring Association (NWFA) in St. Louis, Missouri. She can be reached at dana.rogers@nwfa.org.

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