What is a Good Profit Margin and Why is it Important?
In today’s economic climate a business cannot simply sell its way out of a profit problem. The economy has caused demand to decline and competition is responding by cutting prices in an effort to increase their sales. Unfortunately, excessive price cutting can be disastrous to everyone’s profits.
What is a Good Profit Margin?
This means the profit margin in percentage terms over the total revenue produced. It is the share of revenue earned by each factor of production such as cost of production, selling price, product value and the effort put by workers. The profit margin measures the net gain made by the business over the total cost.
The amount a company makes is only a measure of how well its management of the whole of the business is working. The real measure is whether or not the business can support itself and produce more profitable sales. The actual profit margin or how much profit a company makes is the final answer to the question, “How well can this company make profits?”.
What Can Happen When Profit Margins Aren’t Good Enough?
An under-performing business can become insolvent. The company has limited assets left to sell. Its debts are in arrears, and the people whose money was originally in the company’s pockets are suing for it.
When there is no more money, the company ceases to exist. The industry that an established business operates in determines what is and what isn’t profitable for it.
Why Is A Profit Margin Important?
Profit margins are an important indicator of how well your business is performing. For example, if you run a clothing store and the average person spends $200 a year at your store, you might have a $150,000 profit margin. If you manage your business by the balance in your bank account, you are likely not profitable and will eventually fail.
What Causes Low Profit Margins?
Each business has its own specific set of reasons for the poor profit margins. Sometimes the basic costs of operating are much higher than the profit from each sale. You might not be earning enough profit because your expenses outweigh your sales. It could be the shift in market trends or competition, or perhaps the purchasing power of consumers has declined.
You might not be earning enough profit because your expenses outweigh your sales. It could be the shift in market trends or competition, or perhaps the purchasing power of consumers has declined. Or it could be that something else, such as a manufacturing mistake, made to optimize an overall goal is not having the intended effect.
What Can a Business Do to Improve Profit Margins?
The current market situation requires that businesses use their profits in a way that is best for them and their customers. To determine if profit margins can be improved, a simple look at costs and sales needs will provide the data needed to determine the best method.
By using profit margin data, a business can determine how their business can perform at a more efficient level to maximize profits. A lot of analysis will be involved, but the idea is to determine the top five profit margins that are offered by a business and then work on improving those profit margins.
Consider Focusing On Gross Profit Margin First
Improving gross margins is a powerful method to improve profits. ProfitPro has developed a Gross Margin Matrix that offers a proactive systems approach to increasing your gross margin goal.
To illustrate, a $1,000,000 operation that can increase its gross margin rate by 3% will add $30,000 to their gross margins and a $20,000,000 company will add $600,000 to their gross margins. The Gross Margin Matrix, created by Holt, incorporates key indicators that impact gross margins into a systemized profit improvement plan.
The Gross Margin Matrix is based on the five following key indicators.
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Customer
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Product/Project Mix
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Pricing Policy
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Sales Strategy
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Advertising & Merchandising
Each of these key indicators of gross profit must have goals, measurements, and training to implement behind it.
A gross margin planning system is a sustainable process that has synergy, meaning that utilizing all the components and produce results that are greater than the sum of their parts. The objective of the sample gross margin matrix is to increase gross margin goals by 5% to 10%.
The overall steps to complete the gross margin matrix are:
- Plot all categories, products, and projects which have high gross margin dollars or high margin percentages.
- Develop a sales system that focuses on increasing sales of what is listed in Step 1.
- Identify areas where prices can be increased without losing sales.
- Redesign marketing and sales to attract customers to these services or products.
Example:
| Current | New Matrix Change Results | |
| $1,000,000 | Sales | $1,000,000 |
| 40% | Gross Margin % which is +7.5%* | 43% |
| $400,000 | Gross Margin $ | $430,000 |
| $370,000 |
37% Overhead | $370,000 |
| $30,000 | Profit | $60,000 |
*($430,000 / $400,000 = $30,000 or 7.5% increase in gross profit)
And by following the strategy laid out in the Matrix guide and video to harness its synergy for growth, business managers or owners have the knowledge at their fingertips to go forward and increase their profits.
What Are Your Goals for Profit Margins?
While you are compiling your analysis, take a look at your goals for the year and then develop a plan to achieve those goals. It might be helpful to break down goals into quarterly goals vs looking at profit for the year. It is likely that your company will be less profitable at the start of the year due to overhead or a month that may have an extra pay cycle.
Doing What Your Competition Does…
Competition has always been a major factor in the history of commerce, and there is nothing new about this. The efficient selling and purchasing of products and services will always be a competitive sport, and everyone has to find a way to ensure that they monitor, measure and pay attention to profit.
Cutting prices or making decisions based on what your competitions is do is not an effective way to increase profits. It is simply a race to the bottom which in the end will cause your business to fail.
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