The two kinds of profit margins every small business needs to know

Rahul Dubey owned a successful small manufacturing business that fetched him sales of Rs 1 crore every year. However, recently he noticed a major slip in its profit margins. Now a lot of things were happening in Rahul’s company. Rahul was behind his key contracts, missing deadlines which forced him to pay large money to expedite shipments. His manufacturing process had also grown pretty sloppy causing excessive scrap costs.

In order to solve his problem, Rahul had to re-think about his profit margins and learn some basics of ascertaining profit margins. Here’s what we suggested Rahul when he approached us with a requirement of a finance management software. This is just some basic information we shared with him to understand profit margins and accounting better.

The two kinds of profit margins

For small businesses, it’s imperative that your business must be profitable especially if you are bootstrapped. You need the money for serving your customers, paying your employees and rewarding yourself. Your profit margins are like the measurement of your profitability.

There are two kinds of profit margins that a small business owner must focus on-

1. Operating profit margin

2. Gross profit margin

The operating profit margin is simply a calculation of how much of every rupee in sales ends up as operating profit (before tax) for your small business. For example, if you had Rs 10 lakh in sales and ended up with a pre-tax profit of Rs 2,50,000, your operating profit margin would be 25 per cent. Remember that your operating profit margin is a great way to measure how profitable your business is on an overall basis.

As per this example, if you are able to go from a 25 per cent to a 30 per cent operating margin by say better expenses management, you would earn more profit from that same Rs10 lakh of gross revenue. To be precise, that 5 per cent increase in operating profit margin would lead to a 20 per cent increase in profit.

We don’t want you to worry too much about this math per se but just to give you a feel of the concept of operating profit margin.

The second important type of margin to understand is your gross profit margin. Believe it or not but in Indian businesses, this one is the most misunderstood and least leveraged number for your business.

The gross profit margin is the measure of how much money you have left over from every sale after you take out your cost of production or for acquiring the product or the service that you just sold. Here’s how you calculate it –

Gross Sales (i.e., total sales before any expenses) Minus COGS (the “cost of goods sold” for the sales you made). Gross profit margin is both vital and powerful for the success of your business.

That’s because this margin informs you how much money you have left after you pay the cost to produce and fulfill on a sale to spend on sales, marketing, fixed overhead etc and still have enough left to make a reasonable profit for your time, effort, and risk.

This number also tells you clearly about the overall efficiency of your business.

When you know your gross profit margin, you can get valuable insights about your pricing. It lets you understand which customers, products, or projects are the best margin business to pursue and which you should consider phasing out (or even immediately cutting), and it even helps you spot inefficiencies in your production cycle.

You can easily get such insights through an online accounting software such as Giddh. It has in-built categories and you can add groups and categories as per your industry. If you have any queries about how you can optimize profit margins through accounting software, let us know.