Profit margins: 5 things every startup founder needs to know
Profit margins are an important aspect of starting and running a business. And while reading the word “profit” may either stress or motivate you, we should think about the concept with some leeway.
Here are five things every startup founder needs to know about profit margins.
1. The three types of profit margin
There are three ways to measure profit margin. Let’s look at what they are and how to calculate them.
Gross profit margin
Gross profit margin (GPM) is the relationship between your startup’s gross revenue from sales and the direct cost to produce the goods and services you provide. Your income statement typically lists this in the first section.
GPM indicates how efficiently a business produces a product or service. Depending on your area of business, your startup will have varying types of direct production costs. If your business sells physical products, you’ll have the cost of goods sold (COGS). Other businesses might have a more general direct cost reference.
Here’s the gross profit margin formula:
Gross profit margin = [(Gross profit ➗ Revenue) ✖ 100]
To find the GPM percentage, divide your gross profit by your total revenue, then multiply that total by 100.
It’s better to have a high GPM percentage because it indicates your total gross profit per dollar earned.
Operating profit margin
Operating profit margin (OPM) is the second number that a business looks at on its income statement. OPM focuses on indirect costs.
Most businesses have a range of indirect costs that factor into their bottom line. Here are some examples of reported indirect costs:
Research and development
Marketing campaign expenses
Depreciation and amortisation
When looking at your OPM, you can examine the effects these indirect costs have on your business. So, when looking at your income statement, you can see whether the areas your startup is investing in are positively or negatively affecting your growth.
Here’s the operating profit margin formula:
Operating profit margin = [(Operating profit ➗ Revenue) ✖ 100]
To find your operating profit, subtract your operating expenses from your gross profit (i.e. revenue). Then, to find the OPM, divide your operating profit by your total revenue (i.e. gross profit).
While your company may have a high GPM, its OPM could be low if you have high indirect costs, such as staff salaries, licensing fees or marketing efforts.
Net profit margin
Net profit margin (NPM) is the third number that a business looks at on an income statement. NPM takes into account interests and taxes owed by a business, operating costs and costs of goods sold (COGS).
Essentially, NPM is your profit margin after accounting for everything — it’s your bottom line.
To calculate your NPM, first calculate your net profit. You can do this by subtracting your taxes and interest expenses, operational costs and COGS from your operating profit. Operating profit is also called earnings before interest and taxes (EBIT).
Then, you can calculate your NPM percentage. Here’s the net profit margin formula:
Net profit margin = [(Net income ➗ Revenue) ✖ 100]
To better understand the calculation, follow these steps:
Determine your startup’s net income by subtracting your expenses from your revenue.
Then, divide your startup’s calculated net income by your revenue (also referred to as net sales).
Lastly, multiply that calculated total by 100, which will give you your overall profit margin percentage.
2. Profit is not the only way to benchmark your business
Benchmarking is the process of measuring your business’s success and then comparing the findings against your competitors. That comparison helps you discover areas that can be improved.
But how exactly do you measure success?
You can measure key performance indicators such as products, services and general results. Each type of benchmarking serves a unique purpose that helps businesses reach their goals.
Here are the six most significant types of benchmarking:
Internal: Compare processes within a business
External: Compare to other businesses
Competitive: Compare to direct competitors, specifically
Performance: Set performance standards by analysing metrics
Strategic: Evaluate the strategies of other successful companies
Practice: Process mapping and addressing performance gaps
Additionally, here are some specific benchmark metric examples used for strategising financial and operational goals.
Financial metrics: GPM, NPM, OPM and customer acquisition costs to name a few
Operational metrics: conversion rates, churn rate, amount of cancellations and/or returns and more.
Businesses look at different types of benchmark metrics depending on their size and goals.
For example, a large eCommerce enterprise like Amazon is likely to use a benchmark metric that improves productivity and boosts marketing efforts in order to break into new markets. Whereas, a startup specialising in SEO might use benchmark metrics related to number of page views or link clicks.
[Related: How to calculate burn rate (the right way!)]
3. Investors may be more interested in growth than profit
As a startup founder, profit matters when you’re low on funds, but it’s not the only indicator of success.
Some businesses veer from profitability in their early years so they can invest more revenue into growth. That money might go towards hiring more people, building out their product or service, or acquiring new customers.
For this reason, profitability is not necessarily a deal-breaker when it comes to startups securing investment.
Investors care about long term growth. A startup that is initially profitable but eventually sizzles out is much worse than one that grows steadily and reaches profitability over a number of years.
Businesses that invest in growth early on are likely to become more profitable down the line. In the long run, signs of growth are often more important in an investor's eyes because those signs indicate that they’re going to earn their investment back.
4. Losing customers can be a good thing (sometimes)
Losing customers can be nerve wracking. But it’s not always a bad thing!
Let’s explore a couple of industry examples.
An eCommerce business decides to put its prices up and cut some lower-value items from its inventory.
After calculating their profit margins and customer lifetime value, they discover that some customers are actually losing the business money, because they're only buying low-value items from the website on a one-off basis. These customers do not generate enough revenue to justify the money it costs to acquire them and fulfil their orders.
The company knows that raising their prices will cause them to lose some customers. But as those customers are not generating profit, this is not a bad thing.
An SEO agency offers a range of services including link-building, content optimization, and more. However, the agency only earns profit from clients who use its premium service.
Looking at OPM, the business realises that their account managers are spending a lot of time onboarding and managing clients that don't generate much profit for the company.
The business decides to strip back its offering and focus on its premium services only. They know they will lose some customers, but they also know those customers were never going to generate long-term profits for their business.
Gaining vs retaining customers
Your startup should ultimately be aiming to engage a high number of loyal customers who generate recurring revenue for your business.
By not wasting resources on unprofitable customers, you may find you have more time and money to engage customers who are likely to generate real growth for your business.
5. The right financial infrastructure is crucial
Building the right financial infrastructure into your business is the best way to ensure you keep a firm grip on your profitability metrics, and don’t waste money on needless bank fees.
This is particularly true for global businesses with customers and suppliers around the world.
Many businesses struggle with their accounts because they manage global revenue and expenses across several foreign currency bank accounts. This creates a fractured financial experience, costs a lot of money in bank fees, and makes reconciliation and reporting that much harder.
Airwallex is an all-in-one financial suite which allows businesses to collect customer payments in multiple currencies, pay international suppliers, and manage global expenses, without high fees.
If you’re ready to start scaling your business, sign up for free today.
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