Part of being an effective leader of your small business is to be able to make sense of the numbers and to avoid profitability pitfalls! Understanding margins is important because your business must be able to understand how to properly ensure that its margins are effective enough in order for your business to remain competitive and grow in an ever-changing business environment.
A margin is the difference between the sales price of a good or service and the price the business owner paid to attain that product or service. As a small-business owner you can increase your margins by raising prices, lowering the costs of goods or services sold, or both.
Here are some margin errors to avoid in order to not have a profitability pitfall:
- Going in too low and undercutting all the time –For some businesses, this isn’t a mistake, it’s an entire strategy, and it’s not a very good one. Going in too low all the time might be great for your top-line revenue number, but it wreaks havoc on your bottom-line profit number–the one you will need to survive. You need to profit and price accordingly. You might not get business out of all of your price-conscious customers, but that’s OK. Your competition will–and then they will have to figure out how to profit from the “price shoppers” when there is little or no profit to make.
- Using the same margin for all products –There’s no rule, law or commandment that says all products need the same margin. In reality, slower moving items need higher profit margins. You can afford a smaller margin based on high sales volume. Even then, you should find ways to add value and increase those margins. Because in the end, even those incremental increases over time will make a big difference to your bottom line.
- Not understanding the difference between margin and markup –Margin is always based on sales price. Markup is always based on cost. I once had a client who didn’t understand the difference, and offered a line of products with a 100 percent markup . then had a 50 percent off sale. The end result? The store was essentially selling the line at cost. Don’t make the same mistake.
- Forgetting to take all costs into account . In order to price correctly–every cost needs to be identified. Even “little” things like credit card processing fees–which typically add 1 to 2 percent on every transaction–add up over time. Other items, like delivery or shipping costs, can also sneak up on you. View them as diligently as you would your cost of goods sold as having an impact on your bottom-line.
- Finding out what competition charges and doing the same –Instead of “following” your competition, do a bit more homework and start to discover and uncover the value you truly offer your customers. Then price for value. That way, you are in an excellent position to defend your price against the competition, with a lengthy list of your own “reasons why” your offering is worth its price.
- Setting sales commissions based on sale prices vs. percentage of profit –For companies using a commission-based sales force, this is similar in scope to the margin/mark-up distinction. Commission based on the top-line vs. commission based on the bottom line directly impacts profitability. Again, profit is the only number that matters. Paying commissions out of revenue streams can mean you are literally giving away your company to your sales people.
- Discounting instead of adding value. Discounting takes a toll on profits –At just a 10 percent discount, a typical firm would need to sell 50 percent more units to keep the same profit on the bottom-line. Costs also increase in the “discount” game, so companies can literally discount themselves out of business. Instead of cutting cash out of the deal, ask yourself if there is there a way you can add value to your product or service. This “value added” proposition means you can “give away” something that won’t come out your profits. Done right, it can also add to the experience your customer has of both the transaction and your company. A great experience is key to getting that customer back–which in turn is key to a highly profitable company over time.
Some ways to keep your finger on the pulse of your profitability is by monitoring your profitability ratios:
- Profit Margin – Profit Margin is your net income divided by revenue. Net income or net profit may be determined by subtracting all of a company’s expenses, including operating costs, material costs (including raw materials) and tax costs, from its total revenue. On a rudimentary level, a low profit margin can be interpreted as indicating that a company’s profitability is not very secure. If a company with a low profit margin experiences a decline in sales, its profit margin will decline even further, leading to a very low, neutral or even negative profit margin. Profit margin may also indicate certain things about a company’s ability to manage its expenses. High expenditures relative to revenue (i.e. a low profit margin) may indicate that a company is struggling to keep its costs low, perhaps because of management problems.
- Net Profit Margin – Net profit margin is the ratio of net profits to revenues for a company. Typically expressed as a percentage, net profit margins show how much of each dollar collected by a company as revenue translates into profit. It can give a more accurate view of how profitable a business is than its cash flow, and by tracking increases and decreases in its net profit margin, a business can assess whether or not current practices are working.
- Gross margin – Gross margin is a company’s total sales revenue minus its cost of goods sold (COGS), divided by total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services it sells. The higher the percentage, the more the company retains on each dollar of sales, to service its other costs and debt obligations. Companies use gross margin to measure how their production costs relate to their revenues. Businesses may also use gross margins to forecast how much money they have left over from sales to cover other operating expenses
- Margin – Margin is the difference between a product or service’s selling price and its cost of production or to the ratio between a company’s revenues and expenses. It also refers to the amount of equity contributed by an investor as a percentage of the current market value of securities held in a margin account. Margin is the portion of the interest rate on an adjustable-rate mortgage added to the adjustment-index rate. Margin refers to the difference between revenue and expenses
- Marginal Profit – Marginal profit is the profit earned by a firm or individual when one additional unit is produced and sold. It is the difference between marginal cost and marginal product (also known as marginal revenue), and is often used to determine whether to expand or contract production, or to stop production altogether. Under mainstream economic theory, a company will maximize its overall profits when marginal cost equals marginal product, or when marginal profit is exactly zero. Marginal profit is simply the profit earned to produce one additional item, and not the overall profitability of a firm.
- Profit – Profit is a financial benefit that is realized when the amount of revenue gained from a business activity exceeds the expenses, costs and taxes needed to sustain the activity. Any profit that is gained goes to the business’s owners, who may or may not decide to spend it on the business. Profit is the money a business makes after accounting for all expenses. The first level of profitably is gross profit. Gross profit is sales minus the cost of goods sold. The second level of profitability is operating profit. Operating profit is calculated by deducting operating expenses from gross profit. The third level of profitably is net profit. Net profit is the income left over after all expenses, includes taxes and interest, have been paid.