What are margins – and why are they important?

Kirsty Young Advice and Tips

The numbers in your business always tell a story.

And probably the most important story is that told by your profit margins.

The profit margin is a measure of the degree to which a business makes money, usually expressed as a percentage.

Your profit margin will show you how much money you make for every pound earned in sales income. So, a 30% profit margin means you make 30p for every pound you gain in sales revenue.

Reviewing what your profit margin was and what they are likely to be in the future can be very revealing. It can really help you understand what your business needs to do next to achieve its goals – whether that’s world domination, mega money profits, or just being able to survive!

 

Your gross profit margin

To calculate this, take your total sales income and subtract all the ‘direct’ costs related to providing that service or creating the product. What is left is your gross profit. If you divide your gross profit by your sales income, you get your profit margin.

Example:

Sales Revenue £10,000
Cost of materials -£6000
Cost of delivery -£500
Cost of labour (wages) used to make the above -£1000
Gross Profit £2,500
Gross Profit Margin 25%

So, for every £ you take in, you make 25p.

The basics: To get that margin for this example, take your calculator and

  • Enter 2500
  • Press the divide button
  • Enter 10,000
  • Press the equals button (=)

Then, multiply by 100 and that’s the % profit margin.

 

How cost changes affect this margin

Costs for your business will keep changing. For example, if:

  • You’ve given some inflation busting pay rises and your wage bill is up 10%

AND

  • Your materials have gone up 5%,

Your figures could look like this:

Sales Revenue £10,000
Cost of materials -£6300
Cost of delivery -£500
Cost of labour (wages) used to make the above -£1100
Gross Profit £2,100
Gross Profit Margin 21%

As you can see, you’ve now made less money, and as a result your margin has gone now.

You are now only making 21p for every £ you receive in sales income.

 

Cool stuff you can do with your gross profit margin

It may shock you to know, but us accountants get excited about profit margins, as they can do magic! You can use gross profit margin calculations to play around with various “what if” scenarios.

Scenario 1:

Let’s presume that £10,000 in sales is generated by the selling of 100 chairs (your product).

If you wanted to see how much gross profit you’d make for selling 15,000 chairs, simply take that figure and multiple by your gross profit margin.

So in the first example:

£15,000 x 25% = £3,750

In the second example where your costs have gone up:

£15,000 x 21% = £3,150

What’s happening here is the calculations are presuming that the cost of delivery, materials and wages rise in proportion to the amount you are selling (as they are variable costs).

Scenario 2:

Let’s presume you worked out that you could reduce your costs by buying cheaper, and/or by increasing your prices slightly. This gains you a profit margin of 30%.

On £10,000 of sales that’s £3000 profit. Not far off the same as the £15,000 at 21% – so you’d be doing less work for more money.

Therefore, concentrating on increasing your gross profit margin could make a massive impact on your business profits.

 

Calculating your net profit margin

Noticed that the gross profit doesn’t include overheads such as rent, software, telephones, admin wages, etc? (We knew you would!) This is because they ‘come off’ underneath this gross profit calculation.

For example:

Sales Revenue £10,000
Cost of materials -£6000
Cost of delivery -£500
Cost of manufacturing labour (wages) -£1000
Gross Profit £2,500
Gross Profit Margin 25%
   
Storage Rent -£200
Telephone -£300
Software -£150
Accountant -£500
Admin Wages -£1200
Net Profit £150
Net Profit Margin 2%

The net profit margin is the net profit of £150, divided by £10,000 sales = 2%. As you can see, not a lot was made in this small example.

 

The impact of increasing your gross profit

Where the ‘magic power’ of playing with these figures comes is looking at the impact of increasing that gross profit, to see what you’d need to do to make more money.

Using our previous example of ‘scenario 2’ (30% gross profit):

Sales Revenue (+2% price increase) £10,200
Cost of materials (buying cheaper) -£5640
Cost of delivery -£500
Cost of manufacturing labour (wages) -£1000
Gross Profit £3,060
Gross Profit Margin 30%
   
Storage Rent -£200
Telephone -£300
Software -£150
Accountant -£500
Admin Wages -£1200
Net Profit £710
Net Profit Margin 7%

Big difference, on small numbers.

 

Here’s your challenge

  • Take your own business numbers and use these calculations to play around.

You’d be amazed at the potential results. The numbers will point you in the right direction, so you can assess the overall impact of even small changes. This is absolutely key if you feel like you’re doing a lot of work, for not a lot of money!

At Heelan Associates, we can work with you on these issues as part of our range of business advisory services. We’d love a chat about how we can help, so: