What Does a Low Profit Margin Mean?
A low profit margin means that your business isn't efficiently converting revenue into profit. This scenario could result from, prices that are too low, or excessively high costs of goods sold or operating expenses. Low margins are determined relative to your industry and historical context within your company.
Companies track three different profit margins: gross margin, operating margin and net margin. At each level of your company's income statement, you divided a particular profit level by revenue during the period to determine margin. Gross margin, for instance, is gross profit divided by revenue.
Gross profit equals revenue minus COGS, or variable costs. A starting point for low margins is low price points. If your business doesn't charge what goods are worth, you miss out on additional revenue opportunities. Charging $9.99 for an item that cost you $6 offers limited gross margin relative to charging $12.99 for that same item.
Expenses often are the component of margin that companies struggle to control. High materials or inventory costs, shipping costs or packaging costs can lead to excessive COGS. Building rental, utility fees and salaried labor are among the potentially expensive operating expenses.
Declaring margins "low" is relative. A 30 percent gross margin is very low in some industries or sectors, but it is on par or even high in others. The technology sector had an average gross margin of 49.06 percent as of April 2015, according to CSIMarket. Therefore, a business with a gross margin of 35 percent is well below industry standards. In contrast, a tech company with gross margin of 60 percent is much more efficient. Industry norms vary based on cost structures and competition. A low margin also is relative to your company's previous performance. In general, stable and rising margins signal positive financial health for a business.
In some cases, low profit margins align with a company's efforts to aggressively grow market share. You may sacrifice short-term profit to generate traffic. However, low margins that aren't part of a strategy mean you aren't creating strong profit from your business activities and revenue. Without margin improvements, your business may struggle to keep up with debts and expenses, invest in expansion and distribution income to owners.
After you recognize the factors contributing to your company's low margins, you can take steps to improve profit efficiency. Market research offers insights on whether you have room to raise prices on your goods. Reviewing your supplier options, negotiating lower costs and buying in larger quantities are strategies to lower COGS. Similarly, looking at lower-cost operating opportunities can help with trimming fixed expenses.