Why the Profitability Tracking Feature is Crucial for Your Business

Profitability and profits are two different things that business owners often confuse. They’re two distinct metrics that serve their own essential purpose and, when tracked correctly, can help you make better decisions that drive success.

Profit is one of the main reasons to start a business, alongside following your passion. All business owners pay attention to their profits, and calculating them is simple.

Profit = Total Revenue – Total Costs 

However, profits don’t always signify profitability, and tracking it alone might be misleading.

Consider these two companies, X and Y. Company X has $1,000,000 in revenue and expenses of $900,000, so it makes $100,000 in profits. Company Y is in the same industry but with a revenue of $500,000 and operating costs of $400,000, making the same profit as company X. But are their profitability ratios the same?

No, because company X had to spend more to make the same profit as company Y. This idea is the basis of profit margins, which are expressed in percentages to reveal the profitability of a business.

Gross Profit Margin vs. Net Profit Margin

Both gross and net profit margins are profitability ratios that can help you get a better picture of the financial viability of your business. Understanding the critical details related to these can improve your firm’s financial standing in the long run.

But most people often find it hard to grasp these concepts, labeling them complex accounting. In fact, a recent study found that 60% of small business owners lack confidence in their finance and accounting abilities. Differentiating your gross and net profit margins from your profits shouldn’t be hard.

Gross Profit Margin

This financial metric gives you a general overview of the profitability and efficiency of your business. It expresses gross profit (total revenue minus your cost of goods sold) as a percentage of revenue.

This metric can help you notice your business’s downward trend. If your firm’s profit is increasing, but your expenses are also rising, your gross profit margin could be dropping. Use this formula for calculating gross profit margin:

Gross Profit Margin = (Gross Profit / Total Revenue) × 100

In the example above, company X has a gross profit margin of 10%, while company Y has a gross profit margin of 20%.

Net Profit Margin

The net profit margin is a metric that helps to evaluate the net income generated from the overall revenue (total revenue minus cost of goods sold and operating expenses) and is expressed as a percentage.

The net profit margin can provide insights into operational inefficiencies or expenditure issues that are decreasing margins and slowing the growth of your business. Use this formula for calculating net profit margin is:

Net Profit Margins = (Net Income / Total Revenue) × 100

Continuing with the example from above, company Y is twice as profitable as company X. Since company A spends more to generate the same net profit margins, it’s more vulnerable to an increase in expenses.

Types of expenses

Expenses are not limited to operational costs. They also comprise costs ranging from new equipment, office furniture, company cars, and so on. Small businesses will often spend between $1,500 to $2,500 annually for office furnishings for employees and up to $90 per month per employee for basic office equipment and supplies.

Say you have just four employees, and that adds up to $4.3k+ each year. Add more employees, and you can do the math to see how expensive basic office equipment can be.

Let’s also say that both companies X and Y need cars for their employees. To keep them happy, they decided to pay their car insurance for the year, increasing both companies’ expenses. Since the average cost of a car insurance premium is $1,426 per year, company X’s net profit margins will be more affected as they have more employees than company Y.

This translates to them paying more in expenses.

Why You Need to Track Profit Margins

Helps in Finding Minor Cost Shifts

When running a business, you are rightly concerned about whether you are generating profit. Most businesses usually reinvest the profit they make into the company; this helps them to grow consistently. While this will help them calculate their profits, it might blind them from minor cost shifts.

Tracking your profit margin is an effective method to assess whether your company is profitable. Your profit margins will help you compare and contrast different areas in your business, allowing you to pinpoint areas that might be draining profits. You can increase your profitability by assessing and managing these minor cost shifts.

Your profitability ratio can also help you compare yourself with competitors or against industry standards. If your profit margins are lower than industry standards, you can find areas to cut expenses to increase profits.

Profits Alone Can Be Deceiving

Without tracking the profit margins, you cannot tell the financial health of your business. Tracking profits alone can deceive you and ultimately lead to higher expenses.

From the above example, company X can develop ways to cut expenses to increase profitability. In the same breath, company Y can increase profit margins by increasing its revenue uniformly.

Profits Margins Provide More Realistic Perspective of your Business Health

Going back to the example above, company Y, with a profit margin of 20%, has better financial health than company X, despite both companies generating the same profits. One company is 2x as profitable, but this might not be apparent without looking at profit margins.

Without tracking profit margins and judging your business against industry standards, you might put your business at risk. Any increase in expenses can further hurt profit margins, which might force you out of business.

Helps you Find Expenses That Negatively Impact Your Business

Tracking profitability provides a clear view of your business’s financial health. This allows you to determine your expenses and identify those that might lower your margins.

You can grow your business’s profits by increasing sales, but first, you must control the expenses associated with increased sales. This can be achieved by studying each unit cost for your business and establishing ways to reduce costs where necessary.

An example of expenses that could negatively affect your profit margins in this digital era is paper and paper-based office stationery. You can choose to eliminate it and go digital.

For example, switching to a text-to-pay invoicing system can help you save between $12 to $30 on each invoice that would have otherwise been spent on printing, stamps, envelopes, and so on. The preferred choice nowadays is opting for free invoicing software to send unlimited invoices to clients.

What Should Your Profit Margins Be?

To remain fiscally healthy and competitive, you must pay close attention to your business profitability ratios. This involves keeping up with your firm’s spending and constantly adjusting to optimize profits.

The profit margins of your business will depend on different factors, including your industry, customer base, and location. Different sectors require different profit margins. You can take extra steps to find and compare the average profit margins of your industry when setting one for your business.

As a rule of thumb, a profit margin of 20% is considered excellent, 10% is considered healthy, and 5% or lower is considered poor.

How Do You Calculate Profit Margins

Profit Margin is the percentage of profit your business generates from sales after all expenses have been deducted. You calculate this ratio by subtracting total expenses from total revenue and dividing the results by total costs.

Profit Margin % = [(Total Revenue – Total Expenses) / Total Revenue] × 100

After calculating your profit margins, the results will help you gauge how well your business is managing its finances. Profit margin is also referred to as profit margin, gross profit, and sales ratio.

To calculate profit margins, you must determine your revenue and income.

If your business generates $1,000,000 and has operating costs of $900,000, then

Revenue = $1,000,000
Total Expenses = $900,000
Your income = $100,000
Your Profit Margins = (100,000 / 1,000,000) × 100
=10%

The higher your profit margin ratio, the more profitable your company is. Businesses always strive to increase profitability rather than profits. Sometimes to increase profits, you might have to increase expenses, which hurts your bottom line goal.

Your profitability ratio can help you compare your current and past performance and determine a roadmap for the future.

Similarly, you can compare how your business performs in your industry and guide you if there are any changes you need to make.

Two Approaches to Increasing Profit Margins

The two main factors determining your business profit margins are your revenue and expenses. How well you balance these two will determine how profitable your business is.

With that in mind, they are two approaches you can take to improve your profit margins, raise prices or reduce costs.

1. Raise Prices

The amount you charge for your goods or services will determine how much profit you generate. When you are not making enough profits, you choose to raise the prices of what you sell.

But for this to work, your expenses must remain the same but increase your revenue. But before you take this route, you must conduct enough market research and approach it with great caution.

Low profits are not enough to hike prices, and you risk driving your customers away and exposing your business to an even low profitability ratio. You should raise your prices to be within the industry-accepted ones to maintain your competitive edge.

2. Reduce Costs

The second approach you can use to increase profitability is reducing your cost of doing business. These are both direct and indirect expenses. Carefully evaluate every expense you shoulder and find ways to eliminate or reduce the ones hurting your profit margins.

One smart way of reducing costs is assessing your company unit’s economics to determine where time is wasted and whether you have redundancies. You can get the best tracking software that can help ensure your employees are working optimally.

Strategically optimizing your pricing and cutting costs can help you manage your business profitability well. You can price yourself relatively well, manage your expenses smartly, and cut out all the unnecessary costs that diminish your profits.

Using the “a dollar saved beats a dollar earned” concept, you’ll realize that cutting expenses might be the best approach for your business. Consider these two companies with the same profitability ratio of 20%. Both have revenue of $500,000 and expenses of $400,000.

Company A decided to increase revenue by $20,000 while maintaining the same expenses to increase profit margins.

Profit Margin = ($120,000 / $520,000) × 100 = 23%

So, company A increases its profitability from 20% to 23%.

Company B took a different approach to increase profit margins, cutting expenses by $20,000 to $380,000 while maintaining the same revenue. The business attained the same profit as Company A, $120,000.

Profit Margin = ($120,000 / $500,000) × 100 = 24%

Company B increased its profitability from 20% to 24%, one point more than Company A.

The example above shows that you increase your profit margins more when you save on expenses than when you increase revenue.

Takeaway

Ultimately, keeping track of your overall profit margins is critical to know the financial health of your business. By simply tracking your profits, you can ignore the expenses that eat into your margins.

Follow the formulas listed in this article and implement a tool of your choice. These two approaches will help you keep track of your profit margins and ensure that your business remains on strong financial footing.

First published on September 23, 2022.