What Is a Good Profit Margin for a Small Business?

Three margins that tell different stories

Gross margin shows profit after direct costs, operating margin after overhead, and net margin after everything including interest and taxes.

Each margin is profit divided by revenue, expressed as a percentage.

• Gross margin. (Revenue minus cost of goods or direct costs) divided by revenue. See what is gross profit.
• Operating margin. Profit after operating expenses like rent, salaries and marketing, before interest and taxes. See operating margin.
• Net margin. What remains after all costs, interest and taxes. See calculating net profit.

Look at all three. A healthy gross margin with a weak net margin means overhead is the problem. A weak gross margin means pricing or direct costs are.

How to calculate yours

Divide profit by revenue for the same period, then multiply by 100. Use the same period each time to see trends.

Here is an illustrative example. A shop has $500,000 in annual revenue and $300,000 in direct costs. Gross profit is $200,000, a 40 percent gross margin. After $150,000 of operating expenses, operating profit is $50,000, a 10 percent operating margin. After $10,000 of interest and taxes, net profit is $40,000, an 8 percent net margin.

Run these figures monthly from your profit and loss statement. Our guide to calculating profit margin covers the formulas. If you do not have a clean profit and loss statement, start with the income statement.

Why there is no universal good number

Industries differ. A grocery store runs on thin margins and high volume, while a consulting firm or software company can earn much more per dollar of revenue.

Businesses with expensive inventory, like retail and food, typically earn lower margins than service businesses with few direct costs. Capital-heavy businesses, like trucking or manufacturing, may also run lean. Rather than chase a number from an article, find benchmarks for your industry from trade associations, your accountant or published industry data. Compare your results to your own history first.

Also consider your business model. A high-volume, low-margin model can work if your cash cycle is fast. Review the cash conversion cycle to see how speed offsets margin.

Margin is not the same as cash

A business can show a profit margin and still run out of cash because of timing: slow customers, inventory purchases and loan payments.

Profit is an accounting measure. Cash is what pays the bills. Growth often consumes cash, since you pay for materials and labor before customers pay you. See cash flow vs. profit and economic profit vs. accounting profit.

Watch both. A healthy margin with poor cash timing is a financing problem. A weak margin with strong cash is a pricing problem.

Ways to improve your margin

Raise prices where you can, cut waste, renegotiate supplier costs, drop unprofitable products and customers, and improve productivity.

Work through these levers:

1. Price. A small price increase often beats a large cost cut. Test it on new customers first.
2. Direct costs. Negotiate with suppliers, buy in volume when it pays and reduce waste.
3. Mix. Sell more of what earns the most per hour or per unit.
4. Overhead. Review recurring subscriptions, rent and insurance each year.
5. Productivity. Better scheduling and tools can raise output without adding payroll.

Track the effect of every change for a few months so you know what worked.

Margin and financing decisions

Your margin determines how much debt payment you can afford and how fast an investment pays back. Check it before you borrow.

If your net margin is 8 percent, a loan whose payment eats 6 percent of revenue leaves little cushion. Test any financing against your actual margin. Our guide on how much of revenue can go to loan payments gives a method.

Here is an illustrative example. You finance a $30,000 machine that adds $120,000 of annual revenue at a 20 percent contribution margin, which is $24,000 a year, or $2,000 a month. If financing costs $3,000 over the term, the machine pays back quickly. If it adds revenue at only a 5 percent margin, it does not.

ROI Funder starts from payback math. It considers 500+ FICO, 6+ months in business and $20,000+ monthly revenue. See equipment financing and working capital.