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What are profit margins?

Understanding and making sure you have a good profit margin on your product or service is critical to any businesses success
Rachel Bridge

/ Last updated on 29th October 2017

The first two words you need to learn when starting a business are ‘net profit’. Doing business is not about how many widgets you can sell; it is about how much net profit you can make from the sale of each widget.  If you are not making any profits, you do not have a business – you have a hobby.

Related: How to price your product or service

How it works

Gross profit is the difference between the amount it costs you to make or buy your products and the amount you can sell them to customers for. Net profit is gross profit minus overheads, tax and interest payments, in other words, the profit after all the costs of running the business have been subtracted.

Gross profit shows you how much markup you can put on your products, but net profit is what you are really interested in. Your business can have a fantastic gross profit, but if the running costs are sky high, then you could end up with no net profit at all. So how do you ensure that your business is going to be making enough net profit to be viable?

1. Decide how you are going to add value to what you are selling

a) If you are making the products yourself, then this bit is obvious. A beautifully decorated cake has obviously had value added to it since it started out as eggs and flour. Ditto a handmade greetings card since it started out as a piece of card and some coloured pens.

b) If you are going to be selling products that other businesses have made, then you need to add value in the way that you sell them. Provide your customers with the ease of a one-stop online shop, for example, so they can find everything they need in a particular category in one place. Or provide them with additional services, such as customer reviews or special discounts, or faster delivery times, which they could not get if they shopped for the products elsewhere. The bottom line is that if you are selling a product that people could just as easily buy elsewhere, then you have got to give them a reason to choose to buy from you.

2. Work out where you sit in the selling chain

If you are selling other people’s products or services, you also need to work out exactly where you will slot into the selling chain which runs from manufacturer to customer – and whether there is going to be enough profit margin left for you to make it worth your while. If the industry is set up so that the manufacturer sells to a national wholesaler who sells to a local distributor who sells to the customer, for example, that is already a lot of people in the chain taking their slice of profits, and it is going to be hard to take another slice out for you.

If for example the manufacturer buys his raw materials for £1 and sells his finished product to a wholesaler for £2, and the wholesaler sells it to a distributor for £4, and the distributor sells it to the retailer for £6, and the retailer sells it to customers for £10, you can see that while everyone in the chain gets a slice of gross profit for each product, that there isn’t much room for anyone else in the chain if they want to be able to make a sizeable gross profit themselves. If you are planning to replace the retailer and sell to the customer, then it is easy to see where your profit will come from. And even better, if you are planning to buy directly from the manufacturer and cut out the wholesaler and distributor then it is easy to see where you could potentially get lots of profits. But if you are planning to merely be another link in the chain, selling to other businesses who will then sell on, then beware, as it is not obvious where your profit is going to come from.

3. Look closely at your costs

If you are planning to start up a business selling shoes, for example, work out how much you will be able to sell your shoes for and how much they will cost to make. Then add in everything from marketing costs and delivery costs to the cost of heating and lighting. And don’t forget to include ALL the costs, from the petrol that goes in the delivery van, to the cost of phone calls, to the cost of the shoe boxes. No cost is too small to include – you may not think it is worth including your plastic bags at 10p a go, but you will when you are getting through 5,000 of them a year at a total cost of £500.

If your costs work out to be more than the price you are planning to sell your product or service at, then either go back and re-examine your costs and work out how to reduce or eliminate them – or forget the whole idea. No profits equals no viable business.

4. Think about where the real profits are made in the industry you are planning to enter

Take chocolate. You can make a profit margin by buying it from a wholesaler and then selling it on in a shop or via your website, but you can make a much bigger profit by making the chocolate yourself and then selling it. That way you get to pick up two lots of profit margins and have the added bonus of controlling the whole process from start to finish.

Things to consider

When you are working out how much a product will cost you to make, or how much a service will cost you to provide, make sure you include a figure for your own labour because otherwise, your costs will be artificially low.

While you might be happy not to pay yourself a salary, at least in the beginning, you will definitely have to pay someone else a salary to do the job instead of you as the business grows and you need to be out doing other things. If you haven’t accounted for that cost, and the profit margin is not big enough to absorb it, then your business will be in big trouble.

Top tips

When working out your costs, always include a bit extra for unexpected contingencies. There is bound to be something you have forgotten.

Case study

When Aamir Ahmad started up his first business, a mail-order furniture company, he devoted seven years of his life and a huge amount of money – both his and other people’s – to making it work. But it ended in disaster because the profits just weren’t there to be had. No matter how big he grew the business and no matter how much energy he put into it, there was not enough of a difference between the price he paid to buy the furniture from the manufacturers and the price he could sell it on to customers. Ahmad struggled on but eventually, he was forced to give up when investors refused to put in any more money and the company was sold for a knock-down price.

He said: ‘Looking back, it is quite astonishing how badly planned it was. I had built a business which was never really focused around making money; it was all about growing sales. It got to the stage where we were doubling in size year on year and we had 100 employees, but I still hadn’t built a business that was making money. The business was structured really badly, and I just got it completely wrong.’

Happily, for Ahmad, he didn’t give up there. After taking time out to recover from the experience, he started another furniture business, Dwell, which did have the right profit structure. It started making profits within seven months of opening and now has 19 stores and an annual turnover of £35 million.

Related: What is Value Added Tax?

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