THE IMPORTANCE OF NET PROFIT MARGIN
While you should keep in mind that this sole metric cannot determine how your business is doing, financial experts often refer to net profit margin as the business’s “bottom line” for a reason.
Providing insight into the financial health and stability of the business, net profit margin is critical for lenders to assess the likelihood of defaulting on a loan and is used by investors to determine whether or not they are willing to invest in your business.
Regardless of the size of the company, this metric is a great way to gauge yourself against competitors. Comparing your net profit margin to other peer businesses within your same industry and category allows you to see if you are doing better or worse than your competition.
Simply stated, having a positive net profit margin shows that your business is profitable.
FACTORS: PRODUCT-BASED INDUSTRIES VS. SERVICE-BASED INDUSTRIES
Margins vary greatly by sector and industry. It is important to keep in mind that net profit margin only measures how much money is earned per each dollar of sales and does not determine how much money your business has the potential to make.
In addition to a very wide range of industry types, several factors decide what adds to - or takes away from - a business’s net profit margin.
Let’s take a few moments to go through a couple examples of factors that determine net profit margin of product-based businesses before getting into the different possible factors of your service-based business.
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With net profit margins ranging from 1-3%, grocery stores and supermarkets provide the perfect example of a low-margin product-based industry.
This is due to several factors including the relative low barrier of entry into the industry. A low barrier to entry typically leads to a large amount of competitors, as well as the need to keep an expansive inventory that is constantly turned over.
To make up for these factors, grocery stores must have a strong customer volume and must sell substantial quantities of their products in order to keep the doors open for business.
On the other hand, the growing pharmaceutical industry enjoys much larger net profit margins, with the major manufacturers averaging around 18%.
A couple of the reasons behind this industry’s higher net profit margins include high barriers of entry due to enormous risks and costs associated with research and development as well as compliance requirements in order to get new and effective medicines to market. The pharmaceutical industry also has to move quickly because there is a relatively short amount of time until generic versions of the drugs are able to be sold and undercuts sales.
While the aforementioned reasons make sense for industries selling tangible products, the factors in figuring net profit margin for intangible, service-based businesses can be a little more difficult to determine.
Whether the service is repairing computers, packing and moving for homeowners and renters, tutoring or auditing, there are several factors that need to be considered for these types of business.
- Direct Costs
Direct Costs are the costs that can be fully attributed to the production of a service.
In product-based industries, these costs could include material and transportation. For service-based industries, you’re looking at costs such as the salary of a supervisor who oversaw a specific project for a set amount of time. It could also be a sales commission paid in association with a specific project.
If ABC Company is designing a custom computer program for a customer for their own internal use, then the costs would be assigned to the customer as a direct cost.
- Indirect Costs
Moving beyond direct costs attributed to a particular service, Indirect Costs are the common day-to-day costs of doing business.
Examples of indirect costs include typical overhead costs like rent and utilities, but can also include cleaning supplies, computers, cell phones, costs of technology and office furniture.
There are also several indirect costs which can be associated with employees. Substantial costs accompany health insurance and other benefits, as well as employee training.
Administrative costs are integral to the daily operation and are therefore considered indirect costs.
- Time Costs
You have heard it said, “Time is money.” Collecting and monitoring data to help you figure out just how much time is necessary for a service or project makes projecting your project costs much easier. Time-tracking programs enable you to monitor the productivity of employees and determine how long your company requires to complete certain services.
- Employee Salaries
A marketing director who has been in a senior position within your firm for the last seven years will not be on the same end of the salary spectrum as a young graphic designer who is still getting settled in. For the purpose of accounting for the indirect costs of their salaries, calculating an average hourly rate is beneficial. Your small business accountant can assist you with this calculation.
While a certain level of marketing is vital to your business’ success, it is important not to get carried away. Whether your marketing strategies are handled mostly by your social media manager or if you are running major SEO campaigns, your net profit margin can take a serious hit from advertising costs.
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While small business owners should pay close attention to growing their net profit margin as much as they can, it is important to maintain realistic expectations within your category and industry. Very successful businesses may have lower net profit margins than you might assume.
In addition, depending on the phase that your business is currently in, your net profit margin may be much lower than you expect. During periods of growth where profits are being invested back into the company, this expansion and growth will not be reflected in the net profit margin.
As your business begins to mature, keep in mind that your net profit margin may begin to decrease. This is due to the added expenses that accompany the growth of any company, an example being the hiring more staff members.