The Three Key Metrics Every Business Should Track
Most sales pitches will promise you 7 or 8 figure revenues and focus on the top line, however, as someone smarter than me noted- revenues feed your ego, and profits feed your family.
A lot of times you will hear someone say -our revenues have increased XX percent but what the true question should be-what are your margins? What is your gross profit, operating profit and net profit margin?
Today, let’s delve into all three of these and discuss why this measure is extremely important to running your business.
In a nutshell, all 3 margins are essential financial metrics which help businesses assess their profitability, make informed decisions about their pricing decisions and manage costs proactively and effectively.
To start off with, every business should break their costs into Cost of Goods Sold or Cost of Sales, Operating expenses and non-operating expenses (that is usually reserved for Interest Expense, Depreciation and Amortization and Taxes).
Cost of Goods Sold and Cost of Sales are any costs that are necessary to produce a service or a product. For professional services organizations, usually any software tools as well as their payroll or contractor expenses will be the biggest Cost of Sales expenses.
Operating expenses are any other expenses that are required to operate the business.
Gross Profit Margin
Gross profit margin is essentially a percentage of revenue that is left after deducting cost of goods sold or cost of sales and is calculated as (Revenues-Cost of Goods Sold/Cost of Sales)/Revenues*100
A high gross profit margin indicates the ability to effectively utilize production resources. The higher your gross profit margin, the greater your ability to cover other operating expenses and generate profit.
Operating Profit Margin and Net Profit Margin
The Operating Profit Margin focuses specifically on a company’s ability to manage its operating expenses in relation to revenue. Operating profit margin includes both production costs (COGS or Cost of Sales) and operating costs but excludes interest income, interest expenses, taxes, depreciation and/or amortization and is calculated as Operating Income/Revenue*100
A higher operating margin indicates that the company is generating more income from its core business activities, suggesting effective cost management and revenue generation.
Net Profit Margin takes into account all of the costs of running the business, and is calculated as Net Operating Income/Revenue*100.
Net profit margin provides insights into a company's ability to manage its costs and generate profits from all aspects of its operations. It takes into consideration the broader picture of a company's financial health, factoring in its operating efficiency and its ability to manage various costs effectively.
What is the Importance of profit margins in daily operations?
Performance Evaluation: Gross and net profit margins are crucial indicators of a company's financial health. By monitoring these margins regularly, businesses can assess how efficiently they are utilizing resources, producing goods or services, and controlling costs. Operating margin highlights a company's efficiency in managing its day-to-day operations. A higher operating margin indicates that the company is generating more income from its core business activities, suggesting effective cost management and revenue generation.
Strategic Pricing: Gross profit margin helps businesses determine appropriate pricing strategies. Companies with lower gross profit margins might need to revisit their pricing to ensure that their products or services are generating sufficient profitability after accounting for production costs.
Cost Management: Analyzing both gross and net margins helps identify areas where costs are being managed effectively or where there might be inefficiencies. This information can guide decisions about sourcing, production processes, and supply chain management. Operating margin highlights a company's efficiency in managing its day-to-day operations.
Investor Confidence: Investors often look at profit margins to gauge a company's stability and growth potential. Higher profit margins generally indicate a well-managed business with the potential for better returns on investment.
Budgeting and Forecasting: Profit margins provide essential data for creating accurate budgets and financial projections. This enables businesses to plan for future growth, expansion, and investment opportunities.
Comparative Analysis: Profit margins allow for meaningful comparisons within an industry or across different time periods. This helps businesses understand their relative position and identify areas where improvements are needed.
Strategic Decision Making: When evaluating business decisions such as expanding product lines, entering new markets, or implementing cost-cutting measures, profit margins provide a clear framework for assessing the potential impact on profitability. Operating margin data assists in making informed strategic decisions. It helps identify areas where operational efficiency can be improved, leading to better resource allocation and growth opportunities.
Operational Changes: Companies can use operating margin to assess the impact of operational changes, such as process improvements or cost-cutting measures. Changes that positively affect operating margin can indicate that the company is moving in the right direction.
It’s important to consider industry averages when comparing your profit margins and setting goals.
Click here to see a listing of gross, operating and net profit margins by industry.
If you have multiple revenue lines, it might make sense to track your margins by product or service to truly understand your revenue and cost drivers at a granular level.
Your existing accounting system is a good way to start analyzing your past data and focus on business goals as you track your performance against industry averages.
Integrating your existing accounting system into other cloud based solutions can help you have better visibility into costs and revenues without too many manual interventions.