We all know a business should be profitable, but exactly how profitable and how do you get there? Unsurprisingly the answer to the question of how profitable your business should be is: it depends. Every industry is different, and every business within an industry can be different depending on factors like maturity, competition, geography and more. Profitability varies widely, and it is necessary to do the research when determining what counts as profitable for your business. Some industries, generally those with high overheads, will never have high-profit margins but that doesn’t necessarily make your business ‘unprofitable’.
When talking about the profitability of a business, we are talking about its ‘net profit margin’. A business’ net profit margin is its total revenue minus its total expenses divided by total revenue. For example, if your business brought in $300,000 last year and had expenses of $250,000, your net profit margin is 16%. Obviously the higher your profits, the better, but exactly how profitable should your business be? Well, small business’ profitability regularly range between 5-20% for sustainably profitable businesses.
How do I calculate my business’ ideal profit margin?
To figure out a benchmark profit margin for your business, you need to do your research. An index like the ASX can help you determine the average for your industry, as can research into the profitability of businesses similar to yours. The economy is always changing, so your benchmark for profitability should be flexible. Ongoing research will help you tailor your goals to make sure they are achievable and sustainable. If your business is relatively new, it may be difficult to arrive at a definitive number for an ideal profit margin. This is where financial advisers can generally assist to determine the numbers tailored to your business.
Many expect that in the early days you will have a lower profit margin than when you become more established, but in the service and manufacturing industries, profit margins generally decrease as sales increase. Growth in revenue often leads to increasing overheads, which decreases profit margins. Simply bringing in more money does not mean increases in profits. It is important to balance your finances so that you maintain healthy profit margins as your revenue increases. Another factor which will change your ideal profit margins is your desire to expand. If you are hoping to expand your business, you will need to aim for higher profit margins to cover the costs of future expenses.
How do I achieve my ideal profit margin?
Once you have determined the ideal profit margin for your business, the next step is to figure out how you will get there. If your profit margins already match or exceed the industry averages, congratulations! If not, don’t worry. Now you have a concrete goal and are ready to take steps towards it. To achieve your goal, you first need to calculate the minimum level of revenue to cover your operating costs and help you reach your profit goal. Once you have your turnover number, you have to assess your businesses profit drivers to find points where improvements can be made.
What are the top profit drivers common to most businesses?
- Increasing sales price (turnover)
- Increasing sales volume (turnover)
- Reducing the cost of sales
- Reducing overhead expenses.
Other significant drivers include debt levels, inventory, productivity, product and service quality and employee training. Prioritise which drivers affect your business the most and work towards improving them. Put simply, to increase profits you need to devise strategies to increase revenue and decrease costs and sustain this pattern over the long term.
Your Arabon accountant can advise you on the ideal profit margin for your business and what steps you should be taking to get there. Call us on 1300 ARABON or visit our website to schedule and appointment.