Whether you are a novice business owner or have a flourishing entrepreneur, most folks know that profit is the key to success. Staying out of the red requires that your revenues exceed the costs in your business, creating what is known as a profit margin. Accountants are great resources when business owners want to pay personal attention to and have a solid grasp on their profit margins.

Here is some information on calculating profit margins and the reasons why it is so important for every business to track them.

Types of Calculations

First, profit margins require that you understand the different types of calculations. There are two common types of calculations, one for gross profit and one for net profit. The amounts for both gross and net profit can be found in your Profit and Loss account.

Gross profit is the profit a company makes after deducting the costs connected with making and selling its products, or the costs associated with providing its services. Gross profits will appear on a company’s income statement, and can be calculated with this formula:

Revenue – Cost of Goods Sold = Gross Profit

Gross profits show how much profit the company made after deducting the costs directly related to producing the goods or providing the services they received income for.

Net profit represents how much is remaining after operating expenses, interest, taxes, and stocks have been deducted from a company’s total revenue. Net profit, also referred to as the bottom line, net income, or net earnings, is calculated with this formula:

Total Revenue – Total Expenses = Net Profit

Net profit is most often found on the last line of the income statement, which is why it is referred to as the bottom line.

The Bottom Line

Knowing a business’ profit margin is important because it is the starting point toward achieving a strong bottom line, or net profit. When you have a high gross profit margin, you are in a solid position to have a healthy operating profit margin and net income. For a newer business, the higher your gross profit margin, the quicker you will break-even and begin making a profit.

Knowing Your Business

Being able to knowledgeably calculate and track your profit margin is crucial for understanding the health of your business and is key in indicating a strong business performance. Whether a new business owner or one that has been successful for years, things can change in an instant. As a business owner, you will want to be on the forefront of those changes.

Anticipating Needs

Going hand in hand with being well-informed, knowing your business allows you to see where costs may need to be cut in order to maintain your profit margin. The smartest business strategies and cost-cutting measures are often the ones that are planned in advance, ultimately increasing revenues and catapulting your business into profitable territory.

Cash Flow

Your profit margin impacts your cash flow as well. Companies typically spend money on inventory costs to create or obtain products. When you sell your inventory with a significant markup, you convert each item into a much greater amount than what you originally invested. It is also much easier to invest additional cash into a business venture when you have the confidence in your ability to convert your inventory and sales into a profit.

Determining Cost-Cutting Strategies

While it seems obvious to carefully analyze your competitors and consumers to determine the best price to charge for services and products, researching and implementing cost-cutting strategies may be the best option for increasing your revenue. Often times, by understanding your profit margin, you may find that outsourcing certain job functions, downsizing personnel, or limiting benefits for your employees can lead to greater success and higher profits in the long run.

While no single strategy is going to guarantee long-term success, profit margins often accurately reflect long-term profitability and a business’s resistance to sudden and unexpected fluctuations. If you need help getting started, it is best to get in touch with a knowledgeable accounting and tax service. They can help you keep track of your profit margin in order to implement strategies that keep costs low and revenue as high as possible.