We cannot run efficient businesses without knowing our numbers. And some of the most important numbers are our margins. Margins alone can make or break a business, and understanding them is the key to increasing our profit.
In a small business, we want to look at three margins in particular. Ideally on any given day, a small business owner (and management staff) should be able to recite a current (within the month) version of these margins.
1. Product Margins
The profit margins of each individual product or service. We take the cost of goods (materials & labor) for an item and subtract them from the sale price to give us the gross profit of that item. Then divide the item’s gross profit by the item’s sale price.
Product Example: Shirt A costs $10 to produce and sells for $25. Shirt A makes $15 of profit, which is a 60% profit margin.
Service Example: It costs $550 worth of labor to design a website and it sells for $1500. A logo has a profit margin of 63%.
2. Category Margins
For category margins, we take combine all of the items in a specific retail or service category and divide their gross profit by their total revenue.
Example: A store sold 20 different shirts: 10 cost $15 to produce and sold for $25, and 10 cost $20 to produce and sold for $35. The store made $600 on shirts in revenue, and spent $350 on shirt cost. This means the shirt category has an overall margin of 42%.
3. Gross Margin (or Weighted Gross Margin)
The last margin is the margin of the entire business. This can be calculated in the same way as the categories and individual products, or, can be calculated as a weighted margin for better accuracy in businesses with multiple categories. In a weighted margin, we multiply each category margin by its share of overall revenue, then add all the resulting numbers together. This calculation helps a business determine its break-even point and shows which product categories are most profitable.
Example of Gross Margin:
A store sold $2,500 of apparel that cost them $1200 to produce. The store’s gross margin is 52%.
Example of Weighted Gross Margin:
The store sold $2,000 worth of shirts that cost $900 to produce, and $500 worth of pants that cost $300 to produce. The margin for the shirts category is 55% and the margin for pants is 40%. Shirts generated 80% of the revenue and pants 20%.
To create the weighted gross margin we will multiply the percentage of revenue by category by the category margin. This gives us 44% for shirts, and 8% for pants. We then get a weighted gross margin of 54%.
Our weighted margins for each category show us that shirts are vastly more important to the profit, and the overall weighted margin reflects that finding as well. The weighted margin is slightly higher than the gross margin because shirts make up a significantly larger portion of revenue than pants and have a much higher margin (55% compared to 40%). This means that the pants are responsible for lowering the conventional margin down, and might not be the best product to carry.
Ideal margins do vary significantly by industry, so it’s important that we research our industries fully to understand what reasonable margins are. Knowing the industry standard can especially be useful in drawing a line that prevents us from losing sight of quality in an effort to increase profit margins.
Regardless of how we use them to strategize, knowing the numbers is the first step.