FinancesUnderstanding profit margins - what is a good profit for a small...

Understanding profit margins – what is a good profit for a small business in the UK?

You’re running a small business and it’s doing well, but what’s a good profit margin compared to other businesses in the UK? Once you understand profit margins, how to calculate them, and the average profit margins in the UK, you can start to look at strategies for improving these margins.

It’s important to remember that increasing your sales will not necessarily change the profit margin – and might, if you’re not careful, even reduce your profits as you need to spend more to manage the higher sales.

What is a profit margin?

A profit margin is one measure of your company’s financial health that shows the amount of revenue your company retains after paying all operational costs. For instance, a profit margin of 10% means that a business spends 90 pence of every pound earned on expenses and retains the remaining 10 pence as profit. Higher profit margins normally represent a stronger, financially robust business, while lower profit margins might mean you need to make changes to your business strategies. Though there are lots of exceptions to these rules – for example, if you’re starting up you might make a loss as you grow market share.

Types of profit margins

There are three main types of profit margins that you should be familiar with:

  • gross profit margin
  • operating profit margin
  • net profit margin

Each serves a different purpose and provides distinctive insights into a business’s financial health.

When looking at the types of profit margin, it’s also important to understand two types of costs you have in your business:

Cost of goods sold (COGS): these are the direct costs that are directly associated with making and selling your product or services. For example, this would include raw materials to make a product, storage, transportation, staff costs to manufacture a product. As you might imagine, consultants or professional service companies have very low costs of goods; a company manufacturing a bicycle will have high costs of goods as it needs to buy aluminium, components, tyres, etc and hire engineers to run the machines to make the bikes.

Operational costs: these are the variable costs that are normally needed to sell the products or services and manage the business, for example it would include rent, insurance, accountancy fees, IT equipment, and marketing.

Gross profit margin

The gross profit margin helps determine the profitability of a singular item or a category of products. To calculate this, subtract the cost of goods sold (COGS) from your revenue (which is normally the total sales) for a specific period, divide the result by the revenue, and then multiply by 100 to convert the decimal into a percentage.

( (Revenue – COGS) / Revenue ) x 100 = gross profit margin%

For example, if your company has revenue of £50,000 and COGS of £20,000 then:

( (£50,000 – £20,000) / £50,000) x 100 = 60% gross profit margin

Operating profit margin

To gain a more precise insight into your business’s financial health, you can calculate the operating profit margin. Subtract both operational costs and COGS from your revenue, then divide the result by the revenue and multiply by 100.

( (Revenue – operational costs – COGS) / Revenue ) x 100 = operating profit margin%

For example, if your company has revenue of £50,000 and operational costs of £10,000 and COGS of £20,000 then:

( (£50,000 – £10,000 – £20,000) / £50,000) x 100 = 40% operating profit margin

With operating profit, you normally need to include an element of depreciation. This is the the amount of value by which your equipment has reduced over the year. For example, you might depreciate your IT equipment over 5 years.

Net profit margin

The net profit margin provides the most accurate picture of a company’s overall profitability. After subtracting all your company’s direct cost of goods sold and the indirect or operational costs from the total sales for a specific period, you then also deduct the tax and interest paid and then divide the result by the revenue for the same period to reach the net profit margin.

( (Revenue – operational costs – COGS – tax – interest) / Revenue ) x 100 = net profit margin%

For example, if your company has revenue of £50,000 and operational costs of £10,000 and COGS of £20,000 and also had to pay £5,000 in tax and £5,000 interest on a bank loan then:

( (£50,000 – £10,000 – £20,000 – £5,000 – £5,000) / £50,000) x 100 = 20% net profit margin

What’s a good profit margin?

The definition of a good profit margin varies across different industries. For instance, businesses selling services or consulting firms run by a sole proprietor have little to no COGS, which means they earn almost pure gross profit.

However, other businesses with high COGS, like auto and furniture dealers, can have a much lower profit margin and still be financially healthy.

In the UK, the Government’s Office of National Statistics keeps track of the profitability of companies based in the UK, and its report for December 2019 shows an average profit margin was 9.4% for manufacturing companies and 14.9% for service companies (such as accountants and law firms).

If you compare these numbers with say a software company, the average gross profit margin for software and apps is nearly 72%, and about 54% for other types of information services.

What’s a good profit margin for a new business?

For new businesses, the benchmark for a good profit margin might be different. It’s important to remember that during the initial phases, businesses might have higher expenses and lower revenue, resulting in a lower profit margin. However, as the business grows and stabilises, the profit margin should ideally improve.

Ways to improve your profit margin

Improving the profit margin involves a strategic approach. Here are some ways you can enhance your profit margins:

Negotiate variable costs

One way to improve your profit margins is by negotiating variable costs, such as the cost of raw materials or supplies. By securing better deals with your suppliers, you can effectively reduce your COGS and, in turn, increase your gross profit margin.

Minimise staff costs

Staff or labour costs can be a significant expense for businesses. By streamlining processes, automating tasks, and optimising workforce management, you can reduce labour costs and enhance your profit margins.

Consider raising prices

While it might seem like a risky move, raising prices can lead to an increase in your profit margins, especially if your products or services are in high demand. However, it’s crucial to analyse the potential impact on sales volume before implementing a price increase.

Optimize your customer experience

Whatever type of business you run, spend time looking at it from your customer’s point of view and improve communication, remove confusing or inefficient requests. Companies with a great customer experience normally grow and retain customers more effectively than others.

Optimize the checkout process

If you run an e-commerce website, look at your checkout process – making changes here can significantly impact your sales and, consequently, your profit margins. By making the process user-friendly and secure, you can encourage more purchases, leading to increased profits.

Cater to existing customers

Acquiring new customers can often be more expensive than retaining existing ones. By focusing on customer retention strategies, you can boost repeat purchases, leading to higher sales and improved profit margins.

Summary

Understanding and monitoring your profit margins is crucial for assessing your business’s financial health and making informed decisions. While the definition of a good profit margin can vary depending on various factors, having some general guidelines can help you set realistic profit margin goals for your business. Remember that continuous improvement is key – always look for ways to increase your profits and grow your small business in the UK.

From gross profit margins to operating and net profit margins, each provides a unique perspective on your business’s financial status. Regularly reviewing these figures can help you identify areas for improvement and implement strategies to enhance your business’s profitability.

Written by

Anna Thornhill
Anna Thornhillhttps://gosmallbusiness.co.uk
Anna Thornhill is one of our expert writers. Anna is our specialist editor covering business growth and marketing and makes it her mission to provide small business owners with practical guides that help you step-by-step to grow your business. Anna’s an experienced sales and marketing professional who moved to writing and editorial and helps startups and small business owners with practical advice in growing their business with the latest sales and marketing techniques plus guides to choosing and using sales and marketing technology.

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