What is Profit Margin?
Profit margin is the ratio of profit to revenue or sales. It is calculated in percentages, and it tells you what percentage of sales your company makes on each product that you sell.
Higher profit margins are great, of course, but even if you have lower margins, it doesn't mean your business is doing worse. After all, you can make up the difference through volume.
There are different types of profit margins you will come across:
- Gross profit margin is the difference between the cost of goods sold and revenue. Since it compares your profit against variable costs, it can tell you how stable your profit is.
- Operating profit margin is the company's total operating expenses divided by their net sales or revenue. It tells you how efficient your business is in generating profit through your core operations.
- Net profit margin takes gross margins, and subtracts all other costs (like administrative expense, depreciation, interest, taxes, etc.) to arrive at a number for what percentage of profits are left over.
These are generally terms for the business as a whole. But knowing the margins on your products can help you make the right decision when it comes to pricing.
Pricing Strategies To Think About
Penetration pricing is a popular strategy especially for newer businesses. It involves setting your product prices lower relative to your competitors, in order to attract and gain market share.
While attractive, it's important to keep a close eye on your margins to make sure doing so won't eat into your profits. Bigger competitors may also have the capability to offer their own product at an even lower price point, causing a price war.
Once your business has gained enough traction, you can then raise prices or introduce higher-end products to raise your business' profit margins.
Seasonal markdowns and volume discounts also fall under this strategy. A product with already thin margins will be difficult to mark down any further. It's important to take this into account when you start pricing your products.
Matching your competitors' prices are a viable pricing strategy and is one of the most widely-used strategies.
However, it's important to note that this might not generate enough profit margins, or even cover your cost in producing your own product. After all, bigger businesses often have better negotiating power and can purchase in bulk, as opposed to smaller businesses.
Many businesses opt to use competitive pricing as a way to attract customers, after which they can upsell or side-sell other items or products with higher margins.
Bundling items together to present a more valuable package is another option for businesses who employ competitive pricing.
Cost-based pricing strategies are based on the actual cost it takes to produce your item, fixed and variable costs combined. While this pricing method recovers your costs, the profit margin you might want to apply might not equate to profitability for your business if the market doesn't follow.
Most customers look for value for money, which typically bigger companies with lower cost structures can provide. As a small business, it will be difficult to meet competitors head-on in this market. To deal with this, you can offer premium products or services to attract your customers even if you have a higher price point.
Making Sense of Pricing Strategies
It might be tempting to use the same pricing strategy across your products. After all, as a new business, you'll want to make sure you gain market share and adopting a standard strategy seems like a solid solution.
But applying the same formula or profit margins across your product lines isn't optimized. Even if you only have a few products, your customers have different perceptions on your goods based on different competitors. These perceptions have no basis on your cost or margin. Some products may also have stiffer competition than others.
Always tweak your pricing according to your product and your market. Applying customer segmentation and positioning your products to be more attractive to certain segments may also profit you in the long run. If you have a long-term plan for your pricing, you'll be able to further optimize for the highest profit for your business.
How to Use the Profit Margin Calculator
The profit margin calculator will help you calculate the profit you can make on any one of your products.
- Put together the cost it takes to produce your item, such as raw materials, labor, and other costs. Enter the cost into the “Cost of Item” field in the calculator.
- Determine the markup you'd like to have for your item, in percentage format relative to the cost of your item. For example, most businesses markup their products up to 50%. This means your profit on the product will be 50% of its cost to acquire or produce. If you manufacture your items yourself, you may wish a higher markup to allow for you to sell your products on wholesale. Enter this markup into the calculator under the “Markup” field.
- Click on Calculate and see your margins!
The calculator will show you three numbers:
- Your sale price - this shows you how much you should list your product for in order to meet the markup you want.
- Your profit - this shows you how much profit you have for every item you sell.
- Gross margin - this shows you the gross profit for your item, based on the costs you have included in your calculation.
Note that this does not include fixed costs for your business (costs that need to be paid regardless of output, such as rent, advertising, insurance, etc).
The difference between margin and markup
Gross margin and markup might feel interchangeable at times, but they are not.
Gross margin is the ratio of your product's profit to your sale price.
Markup is the ratio of profit to your cost to acquire or produce your product.
You can arrive at the same price regardless of which method you prefer in calculating your profits. You can calculate your markup, or start with your expected margin.
Our profit margin calculator easily handles calculating the margins for you given your preferred markup.