Money Matters is a series from Sawyer to help you master financial basics.
Profit margins don’t need to be scary! In fact, every business should calculate profit to understand how much money they actually make after expenses. Start by learning the financial building blocks for your business and get ready to dive into margins. Understanding profit margins (aka how much money you're actually making) can help you understand how well your pricing strategies are working. They’ll also help you identify where you can cut down on expenses.
Margin Calculating 101
If you’ve never calculated profit margin, don’t worry. We’re here to walk you through the basics.
There are two common ways to calculate margins:
- Gross Profit Margins: These are used to show how much money was made for a specific area of the business. This calculation takes the total sales for a specific category of goods or services and subtracts the expenses for that same category (otherwise known as cost of goods sold or COGS).
For example, if you wanted to calculate the gross profit of birthday parties for your business, you would do the following:
Birthday Sales - Birthday Cost of Goods = Gross Profit for the Business
- Net Profit Margins. Used to show how much money a business made after all expenses are subtracted. This calculation takes the total revenue and subtracts the total expenses for the entire business.
For example, if you wanted to calculate the total net profit for your business, you would do the following.
Total Business Revenue - Total Business Expenses = Net Profit for the Business
Need help with these terms? Let’s define them! Your total business revenue would be the sum of your expenses, for example the total amount of birthday sales, class sales, and space rental fees. Your total business expenses would be the sum of birthday COGS, class COGS, rent, labor, and general facility supplies.
One of the most standard methods for tracking expenses and revenue is to create a profit & loss statement (P&L). You can work with an accountant or tax professional to get started or create your own using a template (typically one will be included in your accounting software). If you don’t have accounting software, you can use this Google Sheets template to start!
Here’s what you’ll need to get organized:
- A list of all sources of sales and revenue, itemized by category (e.g. classes, camp, parties, events).
- A list of refunds, discounts, associated fees.
- An itemized list of business expenses by category.
- These include transactions made with your business credit cards/checks from your banking account.
- Payroll amounts, taxes, and fees.
- You will want to list any salaried employees separately from hourly payroll so you can easily keep track of increases in variable labor compared to fixed overhead costs.
Once you’ve gathered all of your revenue and expenses for a specific period of time, you can calculate your profit margins using the equations above. Starting from scratch is tough, but the process will simplify once you get the initial work out of the way. Once you set up your P&L template, you can update it on a monthly or quarterly basis with new numbers.
The More You Know
To increase your profit margin percentages, you will either need to reduce your total cost or increase your amount of sales. If there is an area of your business with an extremely low gross profit margin, this can indicate an area of opportunity.
Here are some things to consider while reviewing your business’ margins.
- Gross Profits: Calculate your gross profit margins for all applicable segments of your business (camps, after school programs, classes, events, parties).
- Identify where you are the most profitable - is it because you are keeping costs down or generating a higher volume of sales for that area of the business?
- Identify where you are the least profitable -what factors are contributing to this?
- Identify where you have the most COGS - are there ways that you could potentially reduce supply costs to establish a higher margin?
- Supplies (COGS): Review your ongoing supply costs. As we reviewed previously, your COGS can vary based on the type of activity you are running. Gym classes have little to no variable supplies involved whereas an art class will require more fluctuating costs.
- If you see consistently high COGS, make sure you are keeping track of inventory and only place orders when necessary. If you can manage bulk ordering seasonally, you will often save on shipping and freight costs.
- Make sure you are buying supplies at wholesale prices! As a business, you can set up better rates with companies (even Amazon) to keep costs down.
- Labor Expense: Calculate what percentage of your total sales go to paying for labor expenses.
- If you find that your labor percentage is more than 50%, this can indicate that you may be running more classes than you can afford based on the total number of sales generated. You also might be overstaffing!
- Measuring Success: Check-in on your initial business goals and review on a monthly, quarterly, and annual basis to see how you’re trending.
- Identify areas of opportunity to increase sales.
- If your sales are trending down or remaining flat (staying the same), look at ways to adjust marketing efforts to help increase sales.
- If you are seeing steady increases to your sales, look at identifying the contributing factors so you can repeat for other areas of the business.
You might assume that profit margins start low and increase as the business grows in size. In reality, the opposite is more often the case. In the service and education industries, smaller businesses see a higher profit margin when they start. As sales increase, businesses hire more people and order more supplies. The more people and supplies, the more your overhead expenses increase. This isn’t necessarily a bad thing! As your business scales, your profit margins may decrease but you’ll have a higher sales volume to help sustain steady growth. For even more guidance on how to set up the budget for your small business, check out our article.