Calculate Your Profit Margin in Four Easy Steps
Profit margin is a key financial metric that can tell you instantly how well or poorly your business is doing. Profit margin looks at the difference between your revenue and your expenses and expresses that difference as a percentage of revenue.
While you should know the profit margin for your company as a whole, it is very important to evaluate each area of the business separately. This will provide tremendous insight into the various offerings that you sell.
Below are four steps to calculate your profit margin and five strategies to improve it.
Step 1: Calculate the sales
This sales number could be the sales of a particular product (yoga mats) or a certain service (haircut or massage). Both MINDBODY and Booker offer Sales by Category Reports that can easily provide this information. If your report includes sales tax, you will need to deduct it from your total sales since tax is not a true source of income.
Example: Assume a studio offers yoga classes and sells yoga mats. From their sales reports, we learn that they earned $3,000 from classes and $400 from the sale of 20 yoga mats last month.
Step 2: Calculate the direct costs associated with the sales dollars
The key in this step is to identify the direct costs that are required in order to generate that sale. These are often referred to as cost of goods (or services) sold.
The direct cost for the yoga mats is the amount the supplier charges. If the supplier adds a fee for shipping, we would include that too. In this example, the supplier charges $15 per mat + $100 for shipping all 20 mats.
For appointment-based services or classes, we would use the direct expenses associated with the person providing the service. These expenses could include payroll, payroll taxes, benefits, and commissions. For this studio, the total monthly payroll cost for the yoga instructors is $2,000.
If the service requires products—for example, a colorist in a salon—you would include the costs of the colorist and any supplies (i.e. the color) used.
You would not include expenses like rent, utilities or insurance in these calculations because they are fixed operating costs that do not change based on how much you sell. However, all operating costs would be included when calculating the profit margin for the business as a whole.
Step 3: Subtract the costs from the revenue to get your profit
In this example, our profit would be:
$3,000 (revenue) - $2,000 (payroll) = $1,000 profit
$400 (revenue) - $400 (cost) = $0 profit
The studio sold 20 mats (20 x $15 = $300 + $100 shipping).
Step 4: Divide the profit by the revenue and multiply by 100 to get a percentage
This percentage would be your profit margin.
$1,000 profit / $3,000 revenue x 100 = 33.3%
$0 profit / $400 revenue x 100 = 0%
If we had looked at total sales, the studio appears to be profitable on everything ($1,000 profit from $3,400 of revenue). Evaluating these items separately allows us to identify that the studio is not earning any profit on the sale of the yoga mats. Even if the studio sold 10 times the amount of yoga mats, their revenue would grow to $4,000 but they would still have $0 profit.
Tracking margins will quickly identify any difficulties you may be having in your business—like pricing errors, management problems or accounting issues. It is also an invaluable tool when it comes to growing your business. Margins will show you if there is excess spending, which items are your biggest money makers and which are underperformers.
In order to improve profit margin, there are several strategies we can employ.
- Track everything. Know the costs of everything associated with producing your revenue. Once these costs are known, they can be managed.
- Increase your service/product offerings. Adding additional services or products may help boost your profit margin as long as these new offerings are profitable.
- Cut underperforming services. Recognize quickly if something is unprofitable. While some items may take time to “catch on”—don’t wait indefinitely for that to happen.
- Increase pricing. As with the example above, by increasing the sales price of the yoga mats, the profit margin would increase.
- Decrease expenses. The quickest way to improve your bottom line is by decreasing expenses. Every dollar saved adds directly to your profit and your pocket.
Once empowered with knowledge of your margins, you can make the necessary changes to ensure that your business is not only profitable but sustainable as well.