Many entrepreneurs go into business because they’re passionate about their craft and they love helping customers. Still, at the end of the day, all small business owners are focused on the same thing: making money.
While every industry is different and no two companies within any sector are the same, shrewd businesses are always focused on strengthening their bottom line and increasing profitability.
Most small business owners can’t just open their doors and expect to be swimming in cash overnight. According to the Houston Chronicle, the average business isn’t profitable until its second or third year.
Getting to profitability starts with mastering cash flow. Unfortunately, 60 percent of small businesses have cash flow problems every year. Since cash flow problems are one of the main reasons companies go out of business, entrepreneurs need to focus intently on maximizing profit margins month in and month out. Otherwise, the cash flow river can dry up quickly, making your dreams of building a successful small business that much harder to achieve.
How to calculate your profit margin
In order to optimize your profit margin, you first need to figure out how to measure it. Luckily, there’s a handy formula you can use to calculate your profit margin:
Profit margin = Net income / Revenue x 100
So, if you’ve earned $100,000 on $800,000 of revenue, your profit margin is 12.5%. But what if your margins were 30%? All of a sudden, you’re hauling in $240,000 on that same $800,000 in revenue because you’ve figured out how to optimize your margins.
Generally speaking, the better your profit margins are, the more money you’ll make as a small business owner.
What is considered a healthy profit margin?
While every business is different, there are some general guidelines as to what healthy margins look like. According to the Corporate Finance Institute, 5 percent profit margins are considered low, while 10 percent margins are average and 20 percent margins are high.
That said, just because your small business might have a higher profit margin than another company doesn’t mean you’re making more money than they are.
For example, let’s imagine you made a 20 percent margin on $250,000 in revenue. At the end of the day, you’re putting $50,000 into your pocket. Not bad! Now, let’s imagine someone makes a 10 percent margin on $1 million in revenue. That entrepreneur is stacking away $100,000 each year. Their margin is half of yours, but they’re pulling in twice as much cash.
In other words, while profit margins might measure the health of your business, they have no impact on your overall earning potential.
It’s also worth noting that different kinds of businesses require different margins to work. For example, a fast-food restaurant might be perfectly fine getting by with small margins due to the volume of transactions and overall revenue. On the other hand, an antique store that relies on a few high-ticketed sales a month might need higher margins to maintain profitability and keep the lights on.
Additionally, margins for many businesses tend to shrink as they scale. To illustrate, imagine you decide to start a house painting business by yourself. You’ve been crushing it and are on track to bring in $60,000 this year. Since your expenses are low, you plan on taking in a whopping 75 percent margin on that revenue, pocketing $45,000.
As more and more work piles up, you decide to hire a new part-time employee. The following year, your team of two is able to double that revenue to $120,000. After paying your employee and covering all of your expenses, you’re left with $60,000—good for a 50 percent margin. While your margin is one-third lower than it was last year, your take-home earnings are one-third higher.
What business has the best profit margin?
According to data from NYU, some of the industries with the biggest profit margins include regional banks (23.79 percent), financial services companies (20.13 percent), semiconductors (20.49 percent), software (20.3 percent), and investments and asset management (19.51 percent). Of course, within each of these industries, there are companies that beat those margins and those that fall short of them.
Though some industries might lend themselves to better margins than others, you shouldn’t go into business simply to chase profit margins (starting a semiconductor company might also be a bit of a challenge, too). If you want your company to be successful, you may want to open a business that you’re passionate about.
What industry has the lowest profit margin?
That same NYU data shows that there are a number of industries that are not profitable at all. For example, the average internet-based software company has a profit margin that stands at -5.6 percent.
It turns out that when your business is fueled by venture capital and shares of stock, your business can turn out perfectly fine despite years of losing money. Case in point? Amazon, which is currently worth more than $1.5 trillion at time of this writing, didn’t start cranking out significant profits until 2017.
As for industries that have lower profit margins that are still making money? Some examples include restaurants (5.69 percent), home furnishings (4.63 percent), transportation (3.88 percent), farming (3.81 percent), and general retail (2.79 percent).
How can you grow your business with low margins?
While profit margins won’t make or break your business on their own, the better your margins are, the more money you’ll have leftover at the end of the year. That being the case, you’ll want to focus on doing what you can to improve your margins on a regular basis. With that in mind, let’s take a look at some of the ways you can improve your profit margins—accelerating cash flow while bringing home more money.
1. Figure out where to cut costs
When you scrutinize your operations, chances are you’ll find some places where you can reduce spending and cut costs. Are you getting the best deal on your internet service? Are you paying too much for electricity and heating? Are you paying too much for the supplies you need to keep your business humming along?
From time to time, make sure to analyze to see whether you’re getting the best deals or whether it makes sense to switch to other providers who can meet your needs at a lower price point.
At the same time, you may also want to look into opening a flexible line of credit that your company can tap into on an as-needed basis. That way, if the going gets tough, you’ll have cash reserves on hand to weather the storm and keep operations humming along.
2. Rethink your prices
Costs increase over time. That’s just the way it is. We see this in our grocery bills, our cable bills, and our tax bills. Despite this, many small business owners are hesitant to raise their own prices. They fear that, by doing so, they will alienate their customers and perhaps even lose business.
Yet an easy way to boost profit margins is to increase your prices. If demand for your products and services keeps increasing, the cost of doing business keeps increasing, or your prices have stayed the same for a long time, it might be time to boost your prices.
Need some tips on how to raise prices effectively? Check out this guide to pricing.
3. Eliminate low-margin offerings
Another way to improve your profit margins is by focusing on high-margin products and services and ceasing to offer those that don’t bring in as much money. For example, if you run a landscaping business that has both corporate and residential accounts, you might decide to stop catering to residential clients altogether and instead focus on the more lucrative corporate contracts.
A word to the wise: Don’t eliminate offerings overnight. Give your customers enough of a head’s up so they can find a substitute solution. Otherwise, they might get upset with you, and your business’ reputation could take a hit.
4. Implement customer loyalty programs
Though loyal customers may only account for 15 percent of your customer base, they can be responsible for as much as 70 percent of your revenue. To this end, one way you can boost your margins is by implementing customer loyalty programs that reward loyal customers for their repeat business. For example, delis and sandwich shops often have buy “10 sandwiches, get one free” programs.
It might require some out-of-the-box thinking, but you should be able to come up with some type of loyalty program at your business, which can help increase revenues and drive higher margins.
Here’s to a healthy profit margin for your small business—and one that you continue to fine-tune over time!