“Gross Profit Margin” Definition
Gross profit margin is a metric that measures profit by taking "total sales revenue" and subtracting it by the "cost" to make the product (COGS). For example, if you sell a ham and cheese sandwich for $4 and the ingredients cost $1 to make, the gross profit margin is 75% regardless of tax, labor or electricity costs.
How to Calculate Gross Profit Margin
The formula for calculating gross profit margin is:
Gross Profit Margin = (Net Sales - COGS) / Net Sales
- Net Sales means the total revenue generated from all sales. Make sure to factor in refunds, discounts and allowances.
- COGs means “cost of goods sold” which means the cost of producing those goods E.g. it cost me $1 to make the ham and cheese sandwich.
Example of Gross Profit Margin:
You run a restaurant that generated $600,000 in revenue from food sales.
The “cost of goods sold” (i.e. the cost of the ingredients) was $180,000.
Your gross profit margin is: ($600,000 - $180,000) / $600,000 = 0.7
Therefore your gross profit margin is 70%. This amount is quite normal for profitable restaurants.
Gross vs. Net Profit Margin
Net profit margin takes everything into account including operating costs (employee payroll, electricity bills, equipment costs etc.), taxes and other miscellaneous expenses.
Gross profit margin only takes into account the cost of goods required to make the product.
The formula for calculating net profit margin is the same as gross profit margin, except you add in those additional costs:
Net Profit Margin = (Revenue - Costs) / Revenue
Example of Net Profit Margin:
Your restaurant generated $600,000 in revenue from food sales.
The “cost of goods sold” (i.e. the cost of the ingredients) was $180,000.
The taxes and operating costs from rent, staff, electricity, equipment, kitchen utensils was $390,000
Your net profit margin is: ($600,000 - $180,000 - $390,000) / $600,000 = 0.05
Therefore your net profit margin is 5%.
Whilst 70% is a common gross profit margin for restaurants, most restaurants only have a net profit margin of 2-5%. This is the amount the owner makes.
Average Profit Margins by Industry (2023)
So now that we know the difference between gross and net profit margins, what is a good profit margin to have for your business?
Here are the average profit margins by industry as of 2023:
Why is Profit Margin Important?
Profit margins allow financial analysts to gauge a company’s health and competitiveness in their industry. It allows decision-makers to assess whether to focus their efforts on improving sales volume, profit margins or both at once.
Often, improving one may reduce the other. It’s not uncommon for businesses to yield a lower profit margin when they begin scaling their operations.
Operating Profit Margin
Similar to net and gross profit margins, operating profit margin is a metric that falls in between those two.
As the name implies, it takes into account operating costs and COGS, but not taxes. The formula for calculating operating profit margin is:
Operating Profit Margin = (Revenue - Operating Costs - COGS) / Revenue
Industries With the Highest Profit Margins
In industries where there is no physical product being sold (e.g. SaaS), the COGS will be much lower and profit margins will be higher.
The industries that have the highest profit margins are:
- Finance: 32%
- Software (entertainment): 29.04%
- Transportation: 28.90%
- Tobacco: 20.58%
- Software (System and Application): 19.66%
- Computers and Peripherals: 18.72%
- Information Services: 16.92%
The Importance of Monitoring Profit Margins by Industry
Every industry is unique. Some have higher operating costs but yield higher revenues, while others operate on slimmer margins but have a higher volume of sales. It's crucial to monitor industry-wide profit margins because:
- Benchmarking: Comparing your business's profit margins to the industry average can help identify areas of improvement or highlight your strengths.
- Strategic Planning: Understanding the profit margins of your industry can guide investment decisions, pricing strategies, and growth plans.
- Investment Decisions: For investors, understanding profit margins by industry can help make informed decisions about where to allocate funds.
- Anticipating Market Shifts: Regularly tracking profit margins can give insights into market trends, helping businesses anticipate shifts and adjust strategies accordingly.
It's not enough to merely know your business's profit margins; understanding them in the broader context of your industry is equally vital.
Challenges in Maintaining High Profit Margins
While every business aims to maximize its profit margins, several challenges can affect these numbers:
- Rising Operating Costs: As the cost of raw materials, labor, or overheads increase, they can squeeze profit margins.
- Intense Competition: In industries where competition is fierce, businesses might have to reduce prices, impacting profit margins.
- Regulatory Changes: New regulations or taxes can increase operational costs.
- Supply Chain Disruptions: Events like natural disasters, pandemics, or geopolitical issues can disrupt supply chains, increasing costs and reducing profit margins.
- Consumer Behavior: Shifts in consumer preferences or buying behavior can lead to increased costs in product development or marketing.
It's essential for businesses to be agile, continuously monitor industry trends, and adapt to challenges to maintain healthy profit margins.
Ways to Improve Profit Margins
The best ways to improve profit margins are:
1. Avoid pricing markdowns by conducting and optimizing sales forecasts
2. Improve marketing and sales strategies by analyzing sales data.
3. Add more value to the products
4. Add more perceived value through marketing efforts
5. Maximize upsells
6. Reduce operating costs by eliminating overtime, and improving team efficiency.
7. Lower COGS by getting vendor discounts
8. If you're running paid ad campaigns, learning how to optimize your ads can greatly reduce expenditure.
Last but not least, sometimes it’s best to look at the bigger picture and realize that a lower profit margin on a product can result in higher sales volume, and hence, higher profitability.
Discounts should be used sensibly for personalized offers or sales bundles. This is where having a data analyst, or a data analysis tool like Polymer Search can come in handy.
Businesses with the Best Profit Margins
When considering individual businesses, some stand out for their exceptionally high profit margins. These margins often result from a combination of factors such as brand strength, market dominance, pricing power, and low operational costs.
Tech companies, especially those in software and cloud services, often boast some of the highest profit margins. Giants like Microsoft, Apple, and Alphabet (Google's parent company) consistently report high margins. Their dominance in their respective markets and the scalability of their products contribute significantly to these margins.
Luxury goods companies, such as Louis Vuitton and Gucci, also see high profit margins. Their pricing power, brand reputation, and customer loyalty allow them to maintain substantial markups on their products, which translates to higher profits.
Pharmaceutical companies, especially those with blockbuster drugs, have high profit margins. Companies like Pfizer and Merck benefit from strong patent protections and significant demand for their life-saving or life-enhancing medications.
Niche Market Leaders
Businesses that dominate niche markets can achieve high profit margins. These companies often face less competition and can charge premium prices for specialized products or services.
High Margin Industries
Certain industries are known for their high profit margins, often due to the nature of their business models, market demand, and cost structures.
Software and Technology
Software companies, particularly those offering SaaS (Software as a Service) models, generally have high margins. The scalability of software, coupled with relatively low ongoing production costs, contributes to this profitability.
Healthcare and Biotechnology
The healthcare and biotechnology sectors are known for their high margins. This is partly due to the critical nature of their products and services, and the significant investment in research and development that can lead to highly profitable patented drugs or medical devices.
Energy and Natural Resources
Depending on market conditions, companies in energy and natural resources can have high profit margins. These industries benefit from large-scale operations and often have significant pricing power due to the essential nature of their products.
Consulting and Professional Services
Firms in consulting and professional services typically enjoy higher margins. Their services are based on expertise and experience, which allows them to command premium rates.
Luxury Goods and Fashion
As with individual luxury brands, the broader luxury goods and fashion industry often sees high margins. The ability to set high prices based on brand strength and exclusivity drives profitability in this sector.
Industries can be very broad, for instance, finance can refer to global banking, regional banks, insurance, investing and more. Each of these will have vastly different profit margins.
If your business has a lower profit margin than industry standard, it may be due to this reason. Doing a sales volume analysis can also be useful for these situations.