Profit margin: what it is, how to calculate it and why it is important
Running an eCommerce business is not without its challenges, one of which is making enough money to keep your doors open. Only 20% of companies survive in the eCommerce industry, which means that 80% are not breaking even with their spending or are losing money.
This is why it’s critical to track your profit margin so you can see where you stand and take action to keep the business going.
What is profit margin?
Profit margin is the percentage of sales revenue your company retains after all costs have been deducted. Simply put, it measures how much of the money you make from a sale you keep. The higher your profit margin, the better the financial health of your company.
Markup exists in several forms, with the following being the most popular:
gross profit margin
Gross profit margin shows your company’s profit after accounting for the costs associated with manufacturing and selling your product or service.
Calculating gross profit requires you to subtract cost of goods sold (COGS) from total revenue. Divide the sum by the total revenue and multiply the result by 100 to get the percentage, which represents the gross margin.
Gross Profit = [Total Revenue – COGS] / Total Revenue (x 100)
Note that COGS refers to the direct costs of the product rather than indirect expenses like rent and office supplies.
Calculating gross profit can help you determine if your company is running a profitable operation and if prices need to be changed. If your gross profit margin is low, it could mean that you need to charge more to make a specific item worth selling.
What is the ideal gross profit margin? The ideal gross profit figure varies from industry to industry. For online retail, it is around 45.25%. To get higher gross profit, you’ll need to start charging optimal prices for your products.
operating profit margin
The operating profit margin shows your company’s profit after taking into account variable costs, that is, the indirect expenses associated with running your business.
Compared to gross profit margin, operating margin considers a range of other operating expenses such as utilities, rent, payroll and labor costs, advertising, and insurance, just to name a few.
Calculating operating margin can give you a better picture of your pre-tax earnings and reveal how operating expenses are affecting your company’s profitability.
To calculate operating profit, subtract operating costs from total revenue. Then, divide the sum by the total income and multiply the result by 100.
Operating Profit : [Total Revenue – COGS + Operating Costs] / Total Revenue (x 100)
net profit margin
Net profit margin shows your company’s profit after deducting all your expenses, including cost of goods sold, operating costs, and interest and tax payments.
Net profit : [Total revenue – Total costs] / Total revenue (x 100)
Calculating your net profit can help you gauge the overall success of your business. A high net profit indicates that your company is doing a great job of managing its expenses and making sales.
You can also use net profit to compare your company’s performance with that of your competitors. However, the companies must have roughly the same customer base and cost structure for the comparison to make sense.
What is a good profit margin?
A good profit margin for your business depends on your industry, location, and customer base. As a general rule of thumb, a 10% net profit margin is considered good, while a 20% margin is considered excellent, and a 5% margin is considered poor. If you want to compare your company’s performance based on gross margin and net margin, look at the average profit margin for your industry.
How to increase profit margin
Be willing to lose money on some orders
As an eCommerce business, it’s okay to lose money on some orders if it gives you the chance to get to know the customer better. Today’s customers are so used to mediocre experiences that when a company makes an effort to proactively build a relationship, they are impressed. So how do you invest in the future of your customer relationships? Here are some ideas:
- If a customer wants to return an item, send them a replacement as soon as you share return tracking information instead of waiting until the item arrives at your warehouse.
- When something cheap breaks, send customers a free replacement right away without causing them any hassle with returns.
- A customer is not satisfied with an order? Offer a partial refund to help make up for the unsatisfactory experience.
These strategies will cost a little more in the short term, but will have an incredible impact as you build a loyal customer base that improves the financial health of your business.
Drastically reduces operating costs
A quick and effective way to improve profit margin is to reduce operating costs and expenses.
Although these costs vary from business to business, you should audit the expenses commonly incurred in running a business, including:
- Office space and utilities.
- Employee benefits.
- Work expenses.
- Equipment and maintenance fees.
Then, look at where you can reduce operating expenses and where technology can help. For example, if you provide 24/7 customer service through Facebook and have three employees who work eight-hour shifts, you could reduce operational expenses by using a chatbot outside of business hours.
raise your prices
Many business owners fear that if they raise their prices, customers will abandon them. But if you’re delivering a great experience and proactively resolving customer issues, a small increase in price can do wonders for your business.
When following this strategy, consider using creative or psychological tactics. For example, if you are selling a product at retail and wholesale, you can leave the retail price as it is but increase the wholesale price by 5 euros. This way, customers will get a great deal when they buy in bulk, while your business will enjoy a higher profit margin.
Increase your average order value
Average Order Value (AOV) is the average amount in euros that a customer spends per purchase in your store. Increasing AOV is a simple way to improve your profit margin ratio.
There are several ways to increase your average order value:
- Offer minimum order incentives . You can get higher margins and increase your AOV by encouraging customers to spend a minimum amount. One way to do this is to offer free shipping with a minimum order.
- You use the upsell or cross-sell of complementary items . Instead of suggesting the best sellers in your store, you can recommend products that go well with the items in a visitor’s cart.
- Create bundles or product bundles . Product bundles work very well to increase the perceived value of a customer’s purchase and help provide a better shopping experience. To get people to buy more, create bundles of products that cost less when bought together than individually.
Create a customer loyalty program
Customer loyalty programs are a proven way to increase profitability in the retail and service industry. Sephora, for example, has a customer loyalty program with more than 17 million members, representing almost 80% of the brand’s sales.
Instead of spending money to run new campaigns, you can create a customer loyalty program to quickly increase your profit margin.
You can set up a loyalty program where customers earn rewards for every purchase based on a points system. Once they accumulate enough points, let them choose how to use them, either through discounts or gift cards to help offset the initial cost.