Net profit margin is a key financial metric for business owners.
That’s because it measures the profits a business generates after all operational costs have been taken into account. There are some tax and capital investment considerations to make, but net profit margin is a strong indicator of the owners earnings from a business, or the cash available for distribution. So it couldn’t be more important to a business owner.
With this in mind, in this post we’ll cover:
- Net Profit Margin, Explained
- How to Improve Net Profit Margin
Let’s get right to it!
Net Profit Margin, Explained
Net profit margin (sometimes referred to as net margin) is a financial metric that indicates how efficient a business is at converting revenue into profit after all expenses have been accounted for. It is largely driven by your industry, but also measures your individual performance in managing your operations.
Said another way, net profit margin shows the money your business has left over after paying off all variable and fixed costs as well as operating overheads related to running your business.
Let’s use an example:
When your local pizza shop has annual revenue of $500,000, to calculate net profit margin we need to know the cost of goods sold (say $100,000), employee expenses ($100,000), power and utilities ($50,000), rent ($50,000), and all other expenses ($50,000). In this case the net profit for the pizza shop is $150,000 and the net profit margin is 30% (150,000 / 500,000 * 100%).
How to Calculate Net Profit Margin
As you could see in our pizza shop example, the calculation of net profit margin is quite simple. Nowadays, bookkeeping and accounting software and other business systems calculate net profit margins for you automatically. But It is still important to understand how it is calculated so you can interpret the results.
To calculate net profit margin, you can start by calculating net profit first, which shows the absolute profit after cost of goods sold (COGS) and total expenses:
Net Profit = Total Revenue - Cost of Goods Sold - Total Expenses
The formula to calculate net profit margin as a percentage is:
Net Profit Margin = (Total Revenue - Cost of Goods Sold - Total Expenses) / Total Revenue x 100%
Net Profit Margin = Net Profit / Total Revenue x 100%
The Drivers of Net Profit Margin
Let’s reiterate the drivers of net margin so we know how we can improve performance. By looking at the formula used for calculating the metric, we can see that there are three drivers of net profit margin:
- Cost of Goods Sold, and
- Total Expenses.
So we have revenue, cost of goods sold and expenses to work with, to improve net margins. Let’s look at some ways we can do this.
How to Improve Net Profit Margin
Because revenue, cost of goods sold and expenses are the drivers, the three ways to improve net profit margins are to (1) increase revenue while keeping costs and expenses the same, (2) reduce the cost of goods sold across all sales, or (3) reduce expenses relative to revenue.
To increase revenue while keeping the costs and expenses the same you can:
- Increase prices: Taking a product or service with a price of $100, COGS of $50 and expenses of $25, and increasing the price to $200 does nothing to the COGS or expenses (unless you change the product or service to justify the price increase). So all else equal, if you can increase prices without increasing COGS and expenses, in our example your can increase net profit margins from 25% ((100 - 50 - 25) / 100 * 100%) to 62.5% ((200 - 50 - 25) / 200 * 100%). Beauty!
- Change sales mix: Some of your products or services will have higher margins than others. By encouraging customers to buy your higher margin products and services, it will lift your overall profitability. It’s surprising how many businesses have this opportunity, and it’s often overlooked.
To reduce the cost of goods sold across all sales you can:
- Reduce volume: If you can find ways to use less inputs, then you can reduce your COGS per unit sold. For example, if you typically use 250 grams in a burger, you can reduce this to 200 grams and save the cost on 50 grams of meat. For a service, if you can find ways to reduce the hours needed to deliver the service, say from 100 hours to 75 hours, the difference will increase net margins. Both product and service improvements can be achieved by reducing usage or improving processes.
- Lower prices paid: You can reduce prices paid for your inputs, for example, by negotiating with suppliers for lower prices or discounts. This is a simple way to improve net margins and probably the most common.
To reduce expenses relative to revenue you can:
- Increase employee productivity: As sales revenue grows, if you can find ways to use existing employees more effectively to meet demand, then your employee expenses will not increase in line with revenue.
- Improve usage and utilization: There are certain fixed expenses that you can look to scale down. For example, do you have too much real estate and can you sublease some to another local business? Is there equipment that’s idle you can return to the leasing company?
- Renegotiate terms: You can look at the contracts behind every fixed expense including rent, insurance, utilities, etc. and go to the provider to negotiate down your payments.
If you don’t have a healthy net profit margin (especially compared to your industry), you are simply going to earn less from your business.
That’s why you should continually monitor your net profit margin, compare it to your industry benchmark, continually look for ways to improve it, and sustain those improvements.
Before you go...
We all know that small business is about doing the little things right.
The little optimisations, the high-impact tweaks and the 1% gains you can make to your business to make it a little better, a little more profitable and even a little bit more pleasant to run.
I have interviewed 500+ business owners, surveyed thousands more, and I am always probing for their best tips, tricks and hacks to improve their business. There are three that stand out above the rest and I want to share them with you.
Join my email list for free and I’ll send them to you right now.