How to Set a Profit Margin
Small businesses are founded on core principles and numerical relationships that determine their financial viability. However, every small business is unique, and formulas that work for one business don't necessarily work for another even when they represent widely accepted industry standards. Setting a profit margin is a matter of researching conventions and industry objectives, and then tailoring these numbers to your company's specific circumstances. But the process of setting a profit margin is also empirical and ongoing, and every business owner must regularly evaluate whether the profit margins he has set are sufficient to cover his business and personal expenses.
Project all of the direct costs your business will incur to operate at a level that your anticipated infrastructure can realistically maintain. For example, if you are opening a bagel bakery that will be able to produce 5,000 bagels per day, calculate the labor and materials costs for producing this number of bagels.
Research direct operating cost standards for your industry. There is no single source that contains these numbers for all industries, but this information can usually be found in industry-specific manuals and textbooks. For example, restaurateurs usually aim for ingredients costs and payroll costs of about one-third of gross revenue.
Set a price for your product based on your direct operating costs and the percentage margins specific to your industry. For example, if it costs $1,000 in ingredients and $1,000 in labor to produce 5,000 bagels, set the price at $3,000, or 60 cents per bagel, a price that will allow you to maintain the industry average 33 percent each for food and labor costs.
Calculate the amount of product that you expect your business to produce and sell each month based on your production capacity and the demand you have observed through your marketing research. Using the price you have determined based on your industry average, calculate how much capital you will have left over each month for fixed operating expenses such as rent. Add the projected cost of these fixed expenses to the projected cost of your variable expenses to project your total expenses. Subtract your total projected expenses from your total projected revenue to calculate projected net profit. Divide this projected net profit by your projected gross revenue to calculate your projected profit margin.
Evaluate your profit margin over time to determine whether your projections are realistic and whether the margin you have set is sufficient to cover your business and personal expenses. A profit margin goal that you rarely attain is most likely unrealistic and a profit margin that does not provide enough income for you to pay yourself is most likely insufficient.