Guide to profit margins for small businesses

Profit margin is one way that businesses measure how much money they make.  

Expressed as a percentage, profit margin helps businesses identify what portion of their revenue they keep as profit after all expenses are covered.  

The most basic calculation is often considered:  

Revenue – costs = profit    

From there, you calculate the percentage by dividing profit by revenue and multiplying by 100. This gives you your gross profit margin.  

For example, if your small London bakery generates £10,000 in revenue for the month, and your costs (including ingredients, rent, utilities, and wages) amount to £8,000, your profit might be:  

£10,000 - £8,000 = £2,000

To find the profit margin, you divide the profit by the revenue and multiply by 100:

(2,000/10,000) x 100 = 20%.

Regular monitoring can help you spot troubling trends early and make timely adjustments, so many small businesses calculate their profit margins weekly or monthly. If you’ve taken out business loans, your loan agreement might require regular profit margin reports to ensure your financial viability.  

You can read our guide to small business loans for more information about lender requirements. 

There are various types of profit margins that can offer different insights into your small business’s financial performance.  

Gross profit margin is typically considered the simplest calculation, giving you the most basic understanding of your financial health. Meanwhile, net profit margin is a more complex calculation but can offer the most comprehensive measure of profitability.  

Gross profit margin  

This is the percentage of revenue left after subtracting the direct costs of goods and services sold (COGS).  

For example, for a retail shop, this would include wholesale product costs but not rent or employee wages. This metric can identify if your basic business model is viable and if you’re pricing products appropriately.  

Operating profit margin  

This is the percentage of revenue left after subtracting all day-to-day operating expenses. It includes product costs and things like rent, utilities, employee salaries, and marketing.

Net profit margin

Finally, net profit margin is the actual percentage of revenue that becomes profit after all expenses, including taxes, interest payments, one-time expenses, and any other costs.  

It’s often considered the most accurate measure of a company’s profitability because it reflects what you actually keep. 

Each type of profit margin has a different calculation.  

Gross profit margin

Formula: (Revenue – Cost of Goods Sold) / Revenue x 100.  

Example: if you sell £100 worth of items that cost you £60 to make, your gross profit margin is (100-60)/100 x 100 = 40%.  

Operating profit margin

Formula: (Revenue – Cost of Goods Sold – Operating Expenses) / Revenue x 100.

Example: If you have £100 in sales, £60 in product costs, and £20 in operating expenses, your operating profit margin is (100-60-20)/100 x 100 = 20%.  

Net profit margin

Formula: (Revenue – All Expenses) / Revenue x 100.  

Example: If you have £100 in sales and £85 in total expenses (including product costs, operating costs, taxes, etc.), your net profit margin is (100-85)/100 x 100 = 15%.  

Every business aims to make a profit. However, there’s no universal rule for what a “reasonable” profit margin is.  

A good profit margin varies depending on your business and industry.  

For example, a traditional crafts store might have low profit margins but high sales volumes, while a cybersecurity consultancy might have fewer sales but higher profits per sale.  

Many small businesses see their profit margins fluctuate with market conditions and operational efficiency. Industry benchmarks can provide context, but what’s sustainable can depend on your specific business model and growth stage.  

Generally speaking, a net profit margin of 10% is often considered healthy for many small businesses.  

New business owners might have lower profit margins as they invest in growth.  

Tracking your profit margins over time and comparing them with those of similar companies can help you identify trends and opportunities for improvement.

Business owners use various strategies to affect profitability. However, it’s important to note that no move is guaranteed to increase profit margin.  

Several factors can influence profit margins, including:  

• Pricing  
• Expenses
• Competition.

Many small businesses experiment with strategies such as:  

Cost reduction

Look for opportunities to buy supplies in bulk or negotiate better deals with your current suppliers. You might also find a new supplier with lower prices.

Another option is upgrading to energy-efficient equipment, which can reduce utility bills over time.

Pricing adjustments

There are various ways to price products. Smart pricing changes can improve profitability by influencing customers to spend more. For example, many business owners:  

• Raise prices on their most popular items where customers may be less price-sensitive
• Create packages or bundles of products or services to boost the average order value
• Set minimum order requirements to help ensure each transaction covers their costs.

However, it’s important to note that each pricing strategy has a potential tradeoff.  

For example, while raising prices may enhance your margins, it could cut overall revenue if the volume of sales you make declines.

For more information on pricing strategies, you can read our guide on How to price a product or service.

Operational efficiency

Making your business run more smoothly can impact your profit margins. To achieve this, you might:  

• Invest in employee training to boost productivity
• Implement quality control to reduce errors that waste time and materials
• Track and optimise how time is spent on various activities.

Revenue diversification

Profit margins can fluctuate when you’re relying on just one income stream. To diversify revenue, many businesses seek strategic partnerships with complementary businesses to reach new customers or offer more services. Collaboration lets small businesses share resources, cross-promote, and create new revenue opportunities without significant additional investment.  

Every business is different. What works best for your business can depend on your specific situation, industry trends, and customer expectations.  

Remember that no single approach guarantees success. The most effective approach might involve implementing various strategies simultaneously, adjusting your method based on results and changing conditions.