Not all profit margins in business are created equal. It's easy to assume that the more products you sell, the more profit you'll earn. However, your actual earnings from each sale depend not just on what a customer pays you but also on what the product costs you. Products with high margins earn you the most from each sale, so these sales are especially valuable to your business.
A high profit margin is a sizable spread between what you pay for your products and what you earn from selling them.
Calculating Profit Margin
Profit margin is the amount left over after subtracting your costs from your revenue. You can calculate a profit margin for an entire company by subtracting all of your costs from all of your revenue. Alternately, you can figure the profit margin for any particular product. You can have a high margin company that offers goods and services that consistently cost relatively little to produce. Your company can also offer a mix of products or services, some with higher margins than others.
A gross profit margin shows your net earnings after subtracting the cost of goods sold from gross revenue. Cost of goods sold includes all of the costs directly associated with producing a particular product, especially the cost of materials and labor that goes directly into manufacturing. For a retailer who simply buys and resells, the cost of the physical product enters into this equation, but the cost of the labor to sell it doesn't. By calculating gross margin for a range of products and then comparing these numbers, you can determine which of your products provide you with the highest margins.
A net profit margin shows how much is left over in profit after subtracting all of your operating costs, including fixed costs such as rent, utilities and bookkeeping labor. These fixed costs usually can't be attributed to a single sales channel or product line, but they're an important part of the equation, so they're averaged among all of your offerings when you calculate overall profit margin.
Why Profit Margin Matters
It's important to have a healthy profit margin on your core goods and services because this is the money that goes towards your personal income and building up a reserve of cash for expansion and emergencies. It's especially important to think about gross profit margin when you're first getting your business off the ground because it will be the basis of the business model you'll build on as you bring your company to scale. A business with a 30% net profit margin will earn you a million dollars twice as quickly as a business with a 15% net profit margin.
A high margin business has the necessary foundation for profitability, and its actual income will continue to increase as it grows. A high margin product can provide your business with a cash cow even if all of your products aren't similarly profitable. High margin products can also support a business that carries lower margin products that customers want and need. These lower margin products are sometimes called loss leaders because they bring customers into your store where they'll also purchase higher-margin products if your sales strategy is sound.
High Margin Products
- Luxury items. These make excellent candidates for high margin products because customers are willing to pay high prices for them. The value in a luxury item often comes from its perceived value or the prestige that item conveys at least as much as any inherent quality. This isn't to say that a luxury car isn't built with superior engineering relative to a less expensive model. However, this superior engineering may not entirely justify the price difference.
- Products with value. The value of a product may not stem entirely from the materials or workmanship that go into producing it, but rather from the benefit it offers. Computer software costs relatively little for materials but sells for a high margin once a company has recouped its investment in research and development.
- Products in short supply. Remember the law of supply and demand? If you don't have much inventory of a product but everybody wants one, you can sell that item for a high margin price because customers will pay extra to access the limited supply.
Margins vs. Sales
If you consistently sell high margin products, you'll make plenty of money overall. However, there's no guarantee that the products that will be most successful will earn you the highest returns. In fact, everyday products tend to have lower margins than luxury goods, which bring you the greatest profit per item but are purchased more infrequently. Your business can earn more from sales of low margin staples than from high margin luxuries if you sell mostly staples and only an occasional big-ticket item.
The most sensible approach is to carry a mix of these different types of items: frequently purchased commodities and higher-margin splurges. The lower margin items will earn you steady income by virtue of sheer volume while the high margin offerings will bring in occasional windfalls. By building customer loyalty through sales of everyday affordable items, you can increase the odds that customers will also buy their pricier goods from you.
You can also offer products with lower and higher margins and lower and higher prices within the same sales category. A furniture store might carry basic utilitarian chairs and sofas as well as premium options that sell more sluggishly but bring a higher profit. The less expensive items will make the pricier ones seem more luxurious, and the premium products will make your everyday items seem more affordable.
High Margin Industries
Some types of businesses are inherently more profitable than others because they use business models with consistently higher margins. Businesses that provide services tend to have higher margins than companies that deal with physical goods, and this is no accident: If you aren't selling anything tangible, you don't have to buy materials. The only variable cost that gets subtracted out when you calculate gross profit is the cost of labor.
Accounting is an especially high margin industry, earning an average of 18.3% profit. Legal services and real estate rentals are extremely high margin as well, especially if these companies keep their overhead low. Food and beverage wholesalers and manufacturers tend to have fairly low margins. However, purveyors of grocery staples may still net sizable earnings by virtue of volume because people have to eat every day, but they may only use their accountant's services once a year at tax time.
Advantages and Disadvantages of Higher Margins
The most obvious benefit of high margins in business is that they bring you increased earnings at the end of the day, as long as your customers consistently purchase the higher-margin items you offer. But focusing entirely on high margin items is a risky strategy, especially in a tough economic climate when customers are focused on value. High margin items are beneficial to your bottom line, but they can't carry your business on their own unless you focus on high-end luxury goods.
By understanding the margins you reap on the different types of products you offer, you can develop a mix that offers the benefit of both high and low margin items.