This is a great question that needs a quality answer because it hugely effects the profit and cash levels of yours and every business.
The answer also will provide you with a very important goal too.
Before answering the question, another question needs to be asked – is it the gross, net or operating profit margin that’s important?
Which one is the best measure of a “good profit margin?”
Profit margins are far more important than gross or net profit to understand because the margin is the percentage of profit.
It shows the relationship between two figures, sales income and profit.
That’s important because when revenue of a business doubles, ideally so would the gross and net profit, so all three of these figures change with growth over time.
However, the gross and net profit margins could stay the same, which makes them more important to watch over months as your business grows.
The 3 Different Profit Margins
In any service business there is at least one Cost of Sale – i.e. the technical/hands-on employees’ labour cost.
Without a plumbing or electrical company’s tradespeople, the work can’t be carried out, so they are a Cost of Sale (and should be shown as such on the Chart of Accounts and Profit and Loss Statements).
Unfortunately, a lot of companies don’t have their employee labour allocated to being a Cost of Sale, which makes the Gross Profit and Gross Margin figures far less relevant and important.
The Gross Margin on income (with technical employees considered a Cost of Sale) is a super important figure to know in a service and manufacturing business.
The gross profit of a business has to cover expenses, to make a net profit, so the aim is to increase the GP and Gross Margin in order to have a higher net profit.
The two other types of profit and margins are…
- Operating Profit Margin
- Net Profit Margin
This is where a lot of businesses in the change over to Xero haven’t quite had their Chart of Accounts setup ideally.
Ideally a Profit & Loss Statement will resemble this…
|Total Income - Revenue||$1,000,000|
|Cost of Sales|
|Total Cost of Sales||$400,000|
|Income from grants||$10,000|
|Interest on loans||$2,000|
Other Income is ideally listed after Operating Expenses because Other Income is non-trading or operating income. It’s the same with Other Expenses showing after Operating Expenses.
Operating Profit is profit before Other Income and Other Expenses. Net Profit is then calculated after these two.
Other Expenses are ones not related to ‘normal’ operation of the business.
This whole subject can become very technical, very quickly, but the above table is a good model to better understand your business.
Operating Profit Versus Net Profit
The above table shows both, but one comes before the other.
Operating Profit and Operating Profit Margin are both calculated before Other Income and Other Expenses.
The figures when expressed as a percentage of profit on revenue often vary very little, in the order of 1% to 2%, so we can consider them to be close enough to be the same figure for most businesses, especially when annual revenue starts to exceed $2,000,000.
With all this information addressed, the original question can now be addressed…
What is a Good Profit Margin?
There’s no “recommended” figure for Gross Margin for all businesses, let alone all service or all manufacturing businesses due to a few major variables across all industries.
That’s due to the fact that some businesses may have up to 4 or more Cost of Sale types, such as employees, materials, products, subcontractors and even rent of equipment.
Due to all these variables you need to consider what a good Gross Margin is for your own industry.
Keep in mind that most “benchmark” data does not consider technical/hands-on employee labour as a Cost of Sale, so the Cost of Sales percentage, gross profit and gross margin figures won’t tell the true or full picture, unless you add in the labour cost as well.
This page on the ATO government website has a list of industry types you can look through to find benchmark figures for your own industry.
Here’s an example screen shot of a benchmark page for electrical contractors showing the Cost of Sales as a percentage of revenue…
The Cost of Sales shown would just be for materials only.
Looking at the higher range of figures for the $500,000 revenue, the Cost of Sales is 41% at the highest and employee labour is 35% to give a total Cost of Sales of 76%. That would make the Gross Profit Margin 24%.
The figures are definitely on the high side, but considering the figures are taken from real businesses, they are actual figures.
When gross margin is 24% and expenses still have to come out of that, it means the operating and net profit margin will be quite low.
When it comes to understanding ‘what is a good profit margin’ – the question is most relevant to the Operating or Net Profit Margin figure as the Gross is a big variable from industry to industry.
What is a Good Operating or Net Profit Margin?
Let’s assume these figures are close enough to be the same and discuss Net Profit Margin or “Net Margin”.
There are figures that the “business world” will throw around, based on what’s being achieved, and then there are the figures to strive for that can be achieved.
After 15+ years of looking at hundreds of Profit and Loss Statements to see actual Net Margins, plus discussions about Net Margins with dozens of accountants, who see the figures, the reality is that…
90% of service businesses, over $700,000 revenue, operate with less than a 10% Net Profit Margin
These businesses are nearly always struggling, have low cash reserves and often fail.
The reason they fail is debtors keep increasing to the point of no return and they simply run out of cash.
Ever heard of a cashed up business failing?
Often the fault is said to be “poor cash flow” when in fact, in the majority of cases the fault is the business operating with a low Net Profit Margin.
When the Net Margin is low, it directly reduces how much cash stays in the bank after every sale.
Every sale obviously contributes to the Costs of Sales and the Expenses are necessary to run the business, so every expense also can be associated with every sale.
When the income goes into the bank from a single sale, what effectively comes out is the Cost of Sale for the job, plus the proportion of expenses.
This is best explained with a table, showing two different businesses, with the same revenue but with different Net Margins…
|Net Profit Margin||5%||20%|
|Cash left in Bank after COS & Expenses||$50||$200|
In the above table it shows what happens when a a $1,000 sale is made and the money is banked. After the money is received the relevant Costs of the Sale and the Expenses, proportional to the sale value, needs to come out as well.
The amount coming out of the sale is indicated by the Net Margin.
When a business has a Net Margin of 20%, it means the costs and expenses are 80% of income (if every cost and expense is proportioned into every sale).
In the case above, when the Net Margin is 5% then 95% of the costs and expenses are paid out of the money received.
Can you see how cash flow is greatly influenced by the Net Margin?
The higher it is, all things being the same, the higher the amount of cash in the bank a business will have.
Because of this, there is a figure that through experience of mentoring business owners for decades, and seeing how much cash they had in the bank (a very common discussion point and solution many business owners wanted), a Net Margin figure was identified as being the ideal minimum…
An Ideal Goal Net Profit Margin figure is 15%
That’s a good starting point, at least for 90% of businesses that seem to be under 10%.
Over months of training and tracking cash flow, it’s been seen that when a business reaches that figure the business starts to have ‘enough’ cash to meet its financial obligations and can pay its invoices on time.
It obviously varies from industry to industry as payment terms STRONGLY dictate available cash in the bank. For businesses being paid on average 30 days or more, then a higher figure than 15% will almost certainly be needed to stay “solvent”.
The higher the Net Margin figure, the better!
Every business would benefit from an increasing amount of cash in the bank, however that is extremely uncommon, at least for the 90% of businesses operating with less than 10% net profit margin.
That leads to the next important question…
What Net Profit Margin Figure is Possible?
90% of businesses don’t get beyond 10% Net Margin (when revenue reaches $700,000).
That’s when most overheads have kicked in and the business is established.
At $700,000 these are usually seen as part of the business…
- A premises is rented the business operates from
- An admin person to answer phones and do basic office work has been hired
- Work vehicles have been purchased
- Equipment has been and is still being purchased
Below $500,000 revenue a business often operates with 25% Net Margins or higher, because they don’t have some or all of those expenses being paid for.
At $200,000 revenue its not uncommon for some businesses to have a 50% Net Margin as there’s few expenses and the business owner is working hard, often on their own.
Above $700,000 revenue is where the Net Margin also becomes super important to focus on.
This is the area where “management” of your business becomes super important.
Why? Because of what this graph shows in regards to Net Margins as the Revenue increases…
Even though Revenue and Net Profit both increase each year, the Net Margin can be decreasing by a couple of percent each year.
This small, negative creep is rarely seen or picked up – even by accountants, so business owners don’t notice its happening.
This whole topic of gross and net profit margins, plus more importantly, how to increase both is the aim of the Academy of Business Mastery, and our clients results are outstanding!
What it means in reality is that the cash reserves are decreasing.
There are two stages to business, which are…
- Stage 1 – start up to 2 or 3 employees
- Stage 2 – 3 employees and above
If your business is in Stage 1, your focus needs to be on generating sales. Learning about marketing is super beneficial, not just paying for it. 90% of all marketing is poorly executed, so leads can be hard to obtain despite the business paying for outside suppliers – such as a new website, SEO, Google Ads, and Google Map listings.
Training isn’t expensive, ignorance is. The cost is hundreds, the ignorance cost though is tens or hundreds of thousands.
If your business is at Stage 2, then “management” where you aim t “optimize” what you do is important, to increase how you do what you already do.
For example, you answer the phone, and how you answer the phone and talk to prospects greatly effects your conversion rates from leads to sales, plus your ability to win sales on anything apart from being the cheapest.
Being the cheapest is a race to the bottom and usually leads to business failure.
Looking at what to measure and how to measure is essential to increase Net Profit Margins, in fact it is the No.1 most important ingredient of higher Net Margins.
When it comes to what’s possible with Net Profit Margins, take a look at these client results…
Milton, who was stressed and working hard in his plumbing company. He saw these results in 4 months…
|Before the Academy Training||After the Academy Training|
|Revenue per year $750,000||Revenue per year $998,000|
|Net Profit per Year $22,500||Net Profit per Year $209,000|
Alan – a powder coating manufacturing business owner saw these results during a 4 year span…
|Before the Academy Training||After Our Academy Business Training|
|Revenue per year $450,000||Revenue per year $1.8 Million|
|Net Profit Margin 15%||Net Profit Margin 'Over 35%'|
|Hours work per Week 60||Hours worked per Week optional|
Here’s Chris an electrical contractor’s before and after results, in one financial year…
|Before the Academy||After the Academy|
|Revenue per year $1.5 Million and stagnant||Revenue per year $2.3 Million|
|Net Profit Margin 15% (best)||Net Profit Margin 25%|
|Hours worked per Week 55||Hours worked per Week 32 (when no on holidays)|
Jo and Brad who own a software development company. Their company Net Margin made a big jump in the financial year…
|Before the Academy||After the Academy|
|Revenue around $2 Million||Revenue around $2 Million|
|Net Profit Margin 1%||Net Profit Margin 16.5%|
There’s a few videos of these business owners talking about their success and lifestyle now.
While higher revenues are worthwhile, its the Net Profit Margin that really determines the asset value of an established business.
A Net Margin of zero means no profit, so the revenue could be $10 Million but what value does the business have?
Increasing Net Margins requires very different thinking as its about improving tasks the business already carries out.
Its about team building, systems, KPIs and measuring to find facts, so that your business decisions are made with certainty, employees perform because they have to as they can’t argue with their own KPIs.
Increasing Net Margins changes your whole relationship to your business, which is to say you experience a life, business and profit transformation!
Higher Net Margins create the surplus cash you can use to pay for an extra employee, to completely make working optional, so you can choose to work or not.
That’s true “business freedom” – is that worth making a bit more effort to achieve?
It may sound impossible, and it was to all our clients prior to working with them.
Just like everything in life, things seems impossible, but its easy when you know how and if you have a desire for the “know-how”, book in for a 7 minute chat to discover how it can become a reality for you too.