7 Experts Weigh In On the Future of Accounting
Every industry is impacted by the rise of technology and automation, and for many, that can be an...
The national average for coffee houses is only 2.5%. Puts things in a new perspective, right? Join us and we'll show you what else you can learn when you know how to read between the bottom line. You won't even need a profit margin calculator.
It's that simple.
Proft margin s easy to understand when you break them down into it's most basic parts. We'll start with a glossary of terms.
The cost of goods sold, or COGS is the direct expenses associated with obtaining inventory. For a manufacturer, it's how much it costs to make a product. Buying an item for a resale is COGS for a retailer. Service-based industries don't have inventory and therefore don't usually have a COGS.
In most cases, if a change in a specific expense would affect the amount it costs to get a single unit of inventory, it's COGS. Let's imagine we own a shirt manufacturing business called T-Lines. We changed vendors for buying fabric because it was cheaper through a different supplier. This has a direct impact on how much it costs to make a single shirt. That means the fabric is a part of the cost of goods sold.
Operating costs are indirect costs needed to make a profit. If an item affects the overall price of building inventory, it's usually an operating cost. Manufactures need warehouse space and have service costs for maintaining equipment. Building and maintaining a website and security measures common expenses for a retailer. The needs of service-oriented businesses vary but may include phone services and advertising. T-Lines' rent has gone up. This increases the amount it takes to make all our shirts as a whole. Thus, rent is an operating expense.
Taxes, interest fees, and amortization are all administrative costs. These charges don't have a direct impact on how much it costs to turn a profit, but they are still necessary. As a general rule, if an expense isn't a COGS or cost of operations, it falls into this category. T-Lines has a loan they pay on each month. This money doesn't influence the cost of production but does decrease our profit. Loan payments are an indirect administrative cost.
Revenue is the total amount of income made from selling a product or service. T-Lines generates revenue by selling its products to retail stores. The stores, in turn, resale the shirts to the public to make revenue. A local screen printer brings in revenue by offering his services to our customers at a discount.
Profit is the amount of money kept after taking out expenses. The profit margin is the percentage of each revenue dollar left after paying for expenses. This is a scalable ratio. It's how we were able to compare Starbucks and Dunkin Donuts even though they are different sizes. There are three main types of profit and profit margin: gross, operating and net. We'll provide examples of each in a bit.
You can use profit margin to analyze different parts of your business when you look at them one at a time. Still, looking at them as a whole is the most powerful way to use the information. Doing so provides you a 360-degree view of your company's profits. Each one tells you a bit about a business's efficiency. In an enterprise, efficiency refers to the amount it costs to acquire inventory compared to revenue. T-Lines sells its entire inventory each month through word of mouth. We've never had to advertise. T-Lines is very efficient at selling its shirts.
Gross profit is the dollar amount kept after paying for the cost of goods sold. The percentage of each dollar earned after paying for COGS is the gross profit margin. Gross profit is a perfect starting point for building a budget. It's the money available to spend on operating and administrative costs after paying to produce or buy inventory.
Use the gross profit margin to analyze stock acquisition processes. You can identify areas of opportunity to improve efficiency and increase profits.
We pay our employees $15 per hour and One T-Line employee can produce 3 shirts in an hour. That means it costs us $5 per shirt in labor. It also takes 3 yards of fabric at $2 per yard and two spools of thread that are $1.50 each. Our total COGS per shirt is $13. The shirts sell for $20 apiece and, as we mentioned earlier, T-Lines sells its whole inventory each month.
On average, we make 2,640 per month. That's a revenue of $52,800 and a COGS of $34,320 in total.
Revenue minus COGS and operating costs are the operating profit. The percentage of income left after removing those items is the operating profit margin. Operating profit tells you how much you have left to spend after paying for the cost of doing business. The operating profit margin highlights areas of improvement in management and infrastructure.
T-Lines has the following monthly operating costs:
When you remove all expenses including administrative costs, you're left with net profit. The percentage of each profit dollar that remains is the net profit margin.
Net profit is your bottom line.
Analyze your company's gross and operating profits to identify weaknesses. Then make a budget with your net profit to enact the changes necessary to improve profit and drive growth. Net profit margins give you a broad overview of your company's health. Even if you meet gross and operational goals, a positive net profit is still needed to make money.
T-Lines' administrative costs include $1,500 in employee taxes and a debt that we pay down by $500 per month.
There's no standard for what profit margins should like because it's based on the industry average. What looks good for one business may be detrimental to another. A good profit margin is one that's better than that of the industry standard.
The average gross profit margin for apparel is 49.52% according to NYU's Stern Database. At first, glance, T-Lines' gross profit margin of 35% may look a little low, but we're a brand new company. Many businesses take up to three years to turn a profit.
You can use profit margins to identify areas of opportunity and make informed decisions that influence growth. The best way to explain how is to provide an example. We already know that T-Lines has room to improve its efficiency in its production process. T-Lines has 5 employees whom each makes 528 shirts per month. We can improve our gross profits if we produce more shirts each month. There are three choices:
If T-Lines hires a new employee, the output will change from 2,640 shirts per month to 3,168. The COGS per unit doesn't change, but our labor costs increase COGS to a total of $41,184.
Since the cost of goods doesn't change and still manage to sell our entire stock, the gross profit margin doesn't change. This isn't looking like our best decision.
A T-Lines employee comes to us with some ideas for improving production efficiency. We review the suggestions and decide to move forward with the changes.
After a few months, we run the numbers again and see significant improvement. Our employees can now make five shirts per hour instead of the original three. This changes the cost of goods sold from $13 to $11.
The average units made per month also changes. We're now able to make 4,400 shirts per month. That's even better than if we hired a new employee and we're still able to sell everything! At this rate, we're looking at a total COGS of $48,400 and a revenue of $88,000.
That's a huge step toward meeting the industry average of 49.52%.
After the success we enjoyed changing our processes, we also hired a new employee. Based on our initial findings, we know it won't impact our gross profit margin. Still, a new employee will help us increase production. With the help of our new employee, we make 5,280 shirts in a month. Unfortunately, we're only able to sell 4,800.
In this case, having an extra employee actually hurts our bottom line.
See! We told you a profit margin calculator wouldn't be necessary. While calculating margins is pretty easy, learning from the insights they provide can be a little more difficult. That's where Botkeeper comes in.
Botkeeper is an automated accounting platform. With it, you can generate comprehensive reports for an in-depth look at your company. Sign up for our weekly presentation to take a look at how it works. You can find pricing information here.
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