What is a good profit margin? Industry averages and how to improve yours
As the name suggests, profit margin refers to the money that remains after you deduct your small business expenses. It’s a percentage that measures how profitable your pricing strategy is, how well you control costs, and how efficiently you use raw materials and labor to produce your products or services.
But once you know what profit margin is and why it matters, the next logical question is, “What is a good profit margin for my line of business?” The answer varies by location, industry, business model, age of the business, and growth goals. And major economic events like the COVID-19 shutdown tend to shrink every company’s margins.
Below, you’ll find three formulas to calculate profit margin, a handy list of average profit margins by sector, and tips to give your margins a boost.
Types of profit margin
There are three types of profit margins business owners, accountants, lenders, creditors, and investors rely on. You can calculate your company’s gross profit margin, operating profit margin, or net profit margin.
Each of these three formulas provides unique insight into your financial health, and helps you make informed business decisions. Read our breakdown of each margin to learn more.
Gross profit margin
Gross profit is the revenue that remains after you deduct the cost of goods sold (COGS). COGS refers to the costs necessary to produce or manufacture your products or services. Some examples include raw materials, labor wages, and factory overhead expenses.
Gross profit can be found using the following formula:
Gross profit = revenue – cost of goods sold
After you calculate gross profit, you can determine the gross profit margin using this calculation:
Gross profit margin = (gross profit ÷ revenue) x 100
Generally, gross profit margin is a better way to understand the profitability of specific items rather than an entire business. A business with strong total sales could seem healthy on the surface, but might actually suffer losses if high operating expenses aren’t considered. Calculating gross margin can show you if you’re spending too much time or labor on a certain product or service.
Operating profit margin
Operating profit is the income left after you deduct the cost of goods sold (COGS) and operating expenses (OPEX). We’ve already defined COGS as the direct cost of creating your products or services. By contrast, operating expenses refer to the costs that keep your business up and running. This category includes items like rent, payroll, marketing, and inventory software. Costs like interest payments and taxes aren’t included.
First, calculate your operating profit:
Operating profit = revenue – cost of goods sold – operating expenses
Then, you can use the operating profit margin formula:
Operating profit margin = (operating profit ÷ revenue) x 100
For a more accurate picture overall, it’s best to use the operating profit or net profit margin.
Net profit margin
Net profit is what remains after you deduct COGS, OPEX, interest, and taxes.
Find your net profit using this formula:
Net profit = revenue – cost of goods sold – operating expenses – interest – taxes
After that, plug your variables into the net profit margin formula:
Net profit margin = (net profit ÷ revenue) x 100
Net profit margin is one of the best indicators of company profitability because it accounts for your major direct and indirect costs. And that’s why net income is the bottom line of the income statement, which reports a company’s profit and losses over time. It’s the big takeaway after you’ve tallied up earnings and costs.
Expect differences between your gross, operating, and net margins
A great way to illustrate the differences between the margin formulas is to look at a real-world example. Check out Amazon’s margins as of March 2020:
- Gross profit margin: 26.06%
- Operating profit margin: 5.29%
- Net profit margin: 3.36%
Each margin accounts for a little more of your company spending, so your profits are likely to shrink from formula to formula. That said, your business may have a less drastic drop-off between gross profit margins and the other two margins.
Keep in mind a lucrative global company like Amazon will have operating expenses and other costs that far outstrip most small businesses. So, they can expect their operating and net margins to be thinner.
An NYU report on U.S. margins revealed the average net profit margin is 7.71% across different industries. But that doesn’t mean your ideal profit margin will align with this number.
As a rule of thumb, 5% is a low margin, 10% is a healthy margin, and 20% is a high margin. But a one-size-fits-all approach isn’t the best way to set goals for your business profitability.
First, some companies are inherently high-margin or low-margin ventures. For instance, grocery stores and retailers are low-margin. They have high expenses, as they need to purchase inventory, employ corporate employees and labor workers, facilitate shipping and distribution, and rent bigger facilities as their sales grow. But low-margin goods, like food and some consumer products, are usually easier to sell. A highly competitive market, like the rideshare war between Uber and Lyft, can also create thin margins.
By contrast, businesses like consulting firms and software-as-a-service (SaaS) companies generally have high gross margins. These businesses have fewer operating costs, no inventory, and require less startup capital to launch. Companies that sell high-dollar products, like jewelry stores, can also fall into this category. Read more here about the most profitable and least profitable industries.
Business age and size play a role in profit margins as well. New businesses often have higher profit margins than large or established firms. Generally, there are fewer sales, fewer people on payroll, and therefore, lower overhead costs. As operations expand, margins usually shrink.
A geographic area can also alter margins for businesses in the same industry. For example, a tech company in San Francisco will have wildly different rent and payroll costs than a tech company in Dallas.
Finally, a good profit margin depends on your growth goals. If you plan to take on investors soon, need to finance a large equipment purchase this quarter, or want to expand your services, you’ll need to increase your margins. We’ll give you tips on how to do this soon.
Average profit margins by industry
Your profit margin can tell you how well your business performs compared to other market players in your industry.
Although there’s no magic number, a good profit margin will typically fall between 5% and 10%. Below, we’ve compiled the net profit margins for common small business sectors.
- Advertising: 3.30%
- Apparel: 5.87%
- Auto and truck: 3.04%
- Auto parts: 3.05%
- Beverage (alcoholic): 7.94%
- Beverage (soft): 18.50%
- Brokerage and investment banking: 17.62%
- Building materials: 4.30%
- Business and consumer services: 3.83%
- Computer services: 4.34%
- Drugs (pharmaceutical): 18.38%
- Education: 9.59%
- Electronics (consumer and office): -3.14%
- Electronics (general): 5.70%
- Engineering and construction: 1.00%
- Entertainment: 11.73%
- Farming and agriculture: 2.47%
- Financial services (non-bank and insurance): 26.94%
- Furniture and home furnishings: 5.15%
- Healthcare products: 9.27%
- Household products: 4.73%
- Information services: 19.13%
- Insurance (general): 6.26%
- Investments and asset management: 21.06%
- Office equipment and services: 4.91%
- Publishing and newspapers: -1.64%
- REIT: 15.17%
- Real estate (development): 6.65%
- Real estate (general and diversified): 19.75%
- Real estate (operations and services): 3.59%
- Recreation: 1.15%
- Restaurants and dining: 10.57%
- Retail (general): 2.44%
- Retail (grocery and food): 1.44%
- Retail (online): 4.57%
- Shoe: 10.48%
- Software (entertainment): 20.53%
- Software (internet): 2.07%
- Software (system and application): 19.54%
- Transportation: 3.79%
If you don’t see your industry above, check the full list on the U.S. Margins by Sector page. You can also see the gross margin, operating margin, and other standard financial metrics for each sector.
Ways to improve your profit margin
You can increase profitability by raising revenue, reducing costs and expenses, or doing a combination of the two. Here are some tips to achieve your ideal profit margin:
- Reduce your overall operating costs: These include office space and utilities, materials, supplies, wages and benefits, employee spending, insurance, equipment repair, shipping, and business software. Try to negotiate a lower rate, downgrade, or eliminate any unnecessary services.
- Cut underperforming products or services, or add higher-margin products or services: A break-even analysis can help you figure out whether a product is truly profitable. You can draw inspiration from other companies in your sector or dive into the research on high-margin products for your industry. In any case, you’ll need to weigh the cost of goods sold and operating expenses against your desired selling price.
- Adjust your pricing strategy: Experiment with different product pricing methods like value-based pricing or cost-plus pricing. You may be surprised by how product pricing impacts demand.
- Build brand loyalty: Regularly engaging with your customers and showing customer appreciation has a tangible effect on sales and customer retention. Retaining more customers allows you to reduce your advertising costs.
Profit margin signals a lot about a business. It’s a marker of your profitability, stability, and how attractive you are to investors. You can also use it to understand how you compare with the competition, and evaluate whether your business model is sustainable.
But if you aren’t there right now, don’t worry. Use the strategies above and consider contacting a financial advisor to receive one-on-one guidance.