How profitable is your business? How do your profits compare to other companies in your industry? These are two questions that small-business owners need to consider very carefully before jumping into 2015.
Profitability can be measured in a few different ways, but the basic measure is net profit, which is calculated by subtracting all your expenses including interest, taxes, depreciation and amortization from your revenues.
Sageworks, a leading provider of risk management solutions to financial services and privately held companies, recently published an analysis of net profit margins among privately held businesses. The company analyzed more than 1,000 financial statements daily from its clients and used this information to calculate some interesting statistics on small-business profitability. According to Sagework's data, the following industries have the highest net profit margins for the 12-month period ending in August:
If your business has an annual net profit margin of between 10 and 20 percent, then you're in good company, as that puts you among the most profitable privately held businesses in the country. But what if your business isn't in that range? Or what if you have the potential to make even higher margins? Now's the perfect time to check in on your margins and make a few moves to make them even better in 2015.
1. Understand Where You Make Your Profits
Before you arrive at your net profit margin, you need to take a look at your gross profit. Gross profit is the difference between your revenues (from product or service sales) and your cost of goods sold (COGS). COGS consist of the direct expenses associated with the actual good or service you sell. Gross profit is the money you have available to pay for all your other expenses, such as salaries, benefits, office space, insurance and more. It’s nearly impossible to have a high net profit margin unless you also have a healthy gross profit margin.
2. Prune the Laggards
If you sell only one product or service, you can skip this step. For everyone else, once you have an understanding of your overall gross profit, you have to break it down for each good or service you sell. It’s extremely unlikely that all your products or services have the same gross profit margin. So it’s important to understand how much each item you sell contributes to your overall gross margin. It’s likely that some don’t offer much gross profit and require a great deal of time and effort to manage. These are the profit laggards, and you should seriously consider eliminating them—your time and effort would be better spent developing new products.
3. Rank Your Costs
Once you've determined your gross profit margin and eliminated your low-earning products, it’s time to move to the next section of your income statement—operating expenses. You should rank these costs by dollar amount and try to understand how each cost contributes to your overall business. If you can’t articulate in a clear and simple manner what a particular expenditure does for your business, then you should question whether it's truly money well spent. For most small businesses, the largest expense will be labor, which should be examined closely.
4. Optimize Your Sales Per Employee
The most profitable companies in the U.S. tend to have one trait in common: Sales per employee are high. The revenue generated for each dollar spent on labor (R/E) is an excellent indicator of future profitability. For instance, Netflix generates more than $2.5 million in revenue per employee. This means the company is able to leverage a relatively small base of expensive employees to generate impressive revenue numbers because it's optimized the return on its labor costs. If your business could squeeze out an additional 10 percent in sales from your existing employees, much of that additional revenue would go straight to profits.
5. Add New High-Margin Services
The most profitable sales are those that are made to existing customers. Reach out to yours, and find out what additional services they may be interested in purchasing from you. If it’s possible to develop an online, self-service version of what they want, your intake would be pure profit. Facebook’s gross profit margin is currently 82 percent, while LinkedIn stands at close to 87 percent and Yelp at a mind-boggling 94 percent. You don’t need to transform your business into a social media website, but adding a purely online, self-service component to your product mix can boost your gross margin and improve your net margin significantly.
If you haven't done so recently, now's a great time to calculate your current margins and find ways to improve them in the new year.
Read more articles on small-business finances.