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The Easiest Way To Understand Your Profit Margin

Why Are You In Business?

Let’s face it, you are in business to make money and you do that by providing products and services to buyers.  You have a product or service to sell to others at you sell it at a certain price.  You need to make sales to customers in order to create revenue so that your business makes money.

I am going to assume that you have created a business model and a way to market what you offer. Again, I am making an assumption that you have figured out the sales price you need to charge for each service or product that you sell.  This means that you actually know how much goods sold or services sold you need to create the total revenue for a sustainable business … or have YOU?

Be honest and answer a few questions.

Do you know your direct costs involved in providing your products and services? Do you know what the correct markup is for your services and products?  Have you taken a good look at your variable costs? Have you also taken a very good look at your fixed costs?

I began this article telling you the things you must know as a business owner already knowing that some of it you might not know.  How do I know this?  Well, being a business strategist to over 5,000 clients over many decades it has become clear that most business owners don’t know basic numbers and this is why so many businesses are going under or will go under.  My goal with this article is to prevent this from happening to you.  I look at myself as providing an article as your preventive medicine.

Let me share an example of the types of business owners I talk to each day, who are probably just like you. They want to offer their valuable products and services to people who need them and they want people to get great results from using them and to become long-term client or patient family members.  Here is what I run into each day, and while this is an example, I can point to 10 people a week in a similar situation regardless of their business.

Just the other day I was meeting with a physical therapist who was having business struggles.  I asked him about his gross profit margin percentage and he looked at me like I was speaking a foreign language.  I was talking about how much physical therapy was sold and what ratio of leads actually became paying patient family members.  The owner of the physical therapy clinic had no idea how to respond. He didn’t know his numbers.

While this is an example, this is not unusual. It could be a dentist, chiropractor, massage therapist, yoga studio, dietician, naturopath, coach, consultant, therapist or any other business owner. Most of my conversations about this topic leave the business owner in the dark and unable to respond to these questions.  I don’t know where you are in your business right now and if you can answer the questions any better than the physical therapy owner could or not.  I am not making him or you wrong.  I am merely pointing out that not knowing your numbers can be a recipe for disaster and I want you and him to avoid that.

This is why I decided I had to write this article today.  I am sick to my stomach every single time a business goes under.  In so many cases, probably most cases, it could have been avoided if only they would have understood how profit margins determine everything.  It seems we go into business and believe we need to focus on one thing which is getting qualified leads. Then we get leads and believe we need to focus on closing leads. Then we have to retain the client or patient family members who hire us. This is the dance most business owners are doing.  I want to tell you clearly this will soon harm your business, if it hasn’t already.

I sincerely hope you will let in every word from this article and begin tracking the numbers I will educate you about with this article.  I want for you to have success in your business and long-term sustainability for your business as well.

Maybe you are aware that about 80% of new businesses fail in their first year of business. You might also have heard that after five years only half of that 20% that survive are still in business. Sadly,  only one-third of those businesses who make it past the five-year mark then actually pass the ten-year mark in business.  Those numbers are astounding.  I just don’t believe it has to be this way and I am committed to helping other businesses be here for the long-haul serving their client family members and making profits.

So why do so many business owners fall into these statistics?  Most businesses fail (according to Babson College) due to lack of profits or financial funding.  Numbers do matter and unless you understand how to measure your company’s profitability you have no idea if you are actually creating a viable business.  And if your business doing well today, you need to know your numbers to make sure you are a business that lasts five years, ten years and longer.

Business has to make a profit or you can’t continue to operate the business. Simple, easy fact, yet the average business owner is busy trying to get more leads, more prospects, more client family members, more patients, or more customers. They have their eye on the wrong ball.  I want to help you wake up and become a conscious business owner with your eye on the right ball … profits!

Although there are several ways to measure the profitability of your business, I believe that measuring profit margin is where to begin.  Here we go!

Let’s get down to basics.  What is a profit margin?  This is the percentage of revenue that remains after all expenses are removed and paid.  You calculate this by dividing your revenue minus your expenses (this is your actual profit) by your revenue. So, that is the simple explanation of profitability.

There are actually three different types of profit margin.  Let’s look at these types of margins and fully understand their distinctions. Before we do you need to first be aware of your actual cost of goods or cost of your products or services being sold. This is referred to as your cost of revenues.  Think of it this way, you have expenses to create revenue.  If you sell a product you have material costs and labor costs. If you have a service business you still have costs to provide the service.  So to get your actual margin in either case you would subtract the cost of goods, products or services from your actual revenue. This number is your gross income.  You take that number and divide it by your revenue and this then gives you your gross margin.  As an example, if I sold an item for $100 and it cost me $50 to produce that item, the gross margin would be 50%.

Going a bit deeper, you will realize you have other business expenses that are related to revenue creation. These are your operating expenses which can include your marketing and administrative costs to run your business every day and to grow your business.  When you subtract your cost of goods or services and your operating expenses from your revenue you are left with your operating income.

The figure I like to look at when I am helping a business is their operating margin. This is calculated by taking your operating income and dividing it by your revenue. I like to see this number because I believe it gives you a much better picture of your overall profit health than gross margin does.  It actually shows you how much profit you have doing what you do with your operations and marketing day to day.

Let’s say you spent $1o.00 to advertise the $100 item.  Now your gross margin is cut down by 10%. Before I said you were making $50.00 profit margin. After you remove the 10%, now you are left with $40.00 as your operating margin. We are now looking at more accurate numbers.

In every business, there are also expenses that are not related to day to day operations and marketing costs, as well. These expenses might be taxes, interest, and other things depending on the nature of your business.  I have business owners subtract these expenses from their operating income so they can see their net income.  Net income is how we calculate net margin. I like my consulting clients to be looking at the net margin because this number is most accurate when we look at how profitable a company is.  After we remove taxes and other expenses, their margins will be down again. So, if we said we were making $40 on a $100 sale and had taxes and other expenses, we might have $30 remaining. This is an important number.

Many business owners sell a product or service and look at the top line revenue and believe they are making money.  I do not.  I look at how all of these margins are working in a company knowing that to survive and thrive in business you must have a higher gross margin and must have profitability.  It amazes me when a business owner doesn’t know their marketing costs, costs of providing goods or services or their operating expenses. They are headed for a car crash and they don’t even know it and don’t have their seatbelts on.

As a mentor and a business strategist to small business owners, I have to be certain that my client family members understand the importance of their profitability and why we need to look at profit margins. Instead of hunting for more customers, clients, or patients, we need to understand the different kinds of margins and evaluate how the company is operating today before we rush off to bring in more business.

Let’s look at some of the questions my clients ask.

Frequently Asked Questions

Q: Why is it important to calculate costs of goods (COGS) or costs of services?

A: COGS is an important number to calculate because when you subtract the costs from your company’s revenues you will then see your gross profit ratio. When you increase COGS, your net income will decrease so the goal is always to decrease your COGS to increase your net income.

Q: What is included when calculating operating expenses?

A: Operating expenses include anything in a business that allows that business to operate each day but does not include the production of an item to be sold. Operating expenses include marketing costs, salaries or commissions, employee benefits, pensions, travel, transportation, rent, equipment, repairs, amortization, depreciation, and taxes.

Q: What is a good profit margin?

A: This will depend on the industry that you are in as well as the economy. Some business have a low payroll and operating costs, like business coaching and business consulting, while others may have high rent, equipment, and payroll as well as inventory costs. So, this really depends on what industry you are in.

Q: What is net margin?

A: Net margin is the percentage of revenue remaining after deducting all operating expenses, as well as interest, taxes and preferred stock from the total revenue of a company.

Q: How do I calculate my company’s gross profit margins?

A: This number is taken from your revenues and then deducting the actual cost of goods or services.  You divide your gross profit by revenues to get this number.

Q: What is gross profit?

A: Gross profit is net sales minus the cost of goods sold. (Some people use the term gross margin and gross profit interchangeably. Others use gross margin to mean the gross profit ratio or the gross profit as a percentage of net sales.)

If you have specific questions about your business, watch this new webinar and then contact me.

 

 

 

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