What’s a Good Profit Margin for a New Business?

If your business is new, there are several factors to consider before developing a sense of your ideal profit margin. In this article, we look at some of the basics of what you should consider when you’re measuring profitability and studying your profit margins.

What Is a Profit Margin?

The profit margin is the total percentage of sales that results in profit. You have to subtract all of the expenses that go into running the business in order to get the resulting profit. A company’s profit margin tells interested parties (e.g. investors, creditors, and others) how well it handles its money.

There are several types of profit margins. We’ll look at two of the most common: the net profit margin and the gross profit margin.

Net Profit Margin

A company’s net profit margin, or net margin, measures profit (or net income) as a total percentage of revenue.

It’s typically expressed as a percentage, but in some cases, you may see it reported as a decimal.

Here’s how you figure out the net margin for a business. Take the company’s total sales and subtract the total business expenses incurred. Divide the result by the company’s total revenue. So if your new business brought in $300,000 last year and had expenses of $250,000, your net profit margin is 17%.

Net margins allow companies (and others) to see how well their business models are working and to measure their overall profitability. They are also used to help devise profit forecasts, which is especially useful for individuals who invest in public companies.

Gross Profit Margin

The gross profit margin, or the gross margin, is calculated by subtracting the cost of goods sold (COGS) from a company’s net sales. The result is then divided by its net sales.

It’s usually expressed as a percentage.

Major shifts in the gross margin may indicate that the company needs to make changes to the way it’s being managed. Or it may signal that the company’s products and services may need to be reviewed.

Small business owners use the gross profit margin to measure the profitability of a single product. If you sell a product for $50 and it costs you $35 to make, your gross profit margin is 30% ($15 divided by $50).

The Industry Makes a Difference

Profit margins are very dependent on the industry that a business operates in. Business owners make a higher margin in some sectors compared to others because of the economic factors of each industry. That’s why it’s important to keep the industry in mind (in addition to the business size) when you’re comparing the profit margins of any company with others. You have to make sure that you’re making an apples-to-apples comparison.

Let’s say you own a bakery. You kept really good records and, after doing the math, came up with a net profit margin of 21%. But your friend owns an IT company that installs complicated computer networks for businesses and has a net profit margin of 16%. Does this mean you’re a better business owner because your profit margin is five percentage points better? No. It doesn’t work that way, as the profit margin is industry-specific.

Similarly, you may expect margins of 19.8% as an accountant. If you’re in the food service business, you might only see net margins of 3.8%. Does this mean you should sell your bakery and become an accountant? No. Profit margin doesn’t measure how much money you will make or could make, only how much is actually made on each dollar of sales.

If you’re a consultant, your margins are likely quite high since you have very little overhead. You can’t compare yourself to a manufacturer who rents space and equipment and who must invest in raw materials.

Profit Margins of New vs. Established Companies

Many new business owners generally expect a lower profit margin in the early years of their operations. It’s not that they want to rake in lower profits. Rather, they believe that it takes time, effort, and a lot of money to start a business so making a profit may take some time.

In some cases, there’s an inverse relationship between profit margins and sales. For instance, profit margins in the service and manufacturing industries decrease as sales increase. Businesses in these sectors may see a 40% margin until they hit around $300,000 in annual sales. That’s about when the business has to start hiring more people. Each employee in a small business drives the margins lower.

The Bottom Line

In the beginning, when your company is small and simple, margins could be quite high. You don’t have a large workforce and other substantial overhead expenses. As your sales increase and your business grows, more money comes in. But your margins will likely shrink because you’re probably hiring more people, investing in bigger facilities, and expanding your product line. Simply bringing in more cash doesn’t mean you’re making a bigger profit.

Remember, as your business expands, tend to its margins. Larger sales figures are great, but make sure you’re earning maximum money on those sales.