Profit margin

What does 'profit' involve?

Profit is a complex concept. Business economics uses at least 5 concepts at the level of each activity: the trading margin (can be + or –), the gross margin (+ or -), the operating result (i.e. profit or loss), the result before taxes (again + or -) and the net profit (or net result). The three most important parameters that determine whether an entrepreneur/company makes a profit or a loss are:

• the turnover, which is the sum of all sales over a given period
• the sales or (profit) margin on each sale, which is the difference between the purchase price of a product – or a purchased service – and the resale price. If a bar stool costs € 85,- to buy and is sold at € 125,-, the margin on the sale is € 40,-
• the costs the company incurs to operate, from staff and electricity to postage stamps.

Anyone who has a high turnover but barely makes anything per sale will not make a profit at the end of the day because the costs cannot be covered. Anyone who achieves a large margin on each sale but barely gets a customer through the door runs the same risk. Finally, anyone who achieves a solid turnover with a healthy sales margin but does not keep an eye on costs will very probably make a loss.

Types of margins

The trading margin is the difference between the invoice amount, or what (for example) a supermarket takes at the till, and the price of the goods supplied. If it is not high enough – which differs per sector – a loss is inevitable.

For a one-to-one product the calculation is simple because of the direct relationship between purchase and sale. But what about a composite product: the filter coffee that the tavern owner serves to a customer? There, the cost of the filter, the sugar cube, the milk portion and the biscuit come into play (leaving aside the serving cost and the water for a moment). Here the trading margin is already quite different, and can really only be calculated at a bundle level (e.g. per 1,000 units).

It is even more difficult when a product is supplied together with a service: the door of a kitchen cabinet that you purchase but first fit with a handle and two hinges. The preparation time in the workshop is also a cost element. A frequently used way of working in that case is with intermediate margins:

• The trading margin is then the difference between the selling price and the cost of the hinges, plus the handle, plus the door panel itself, plus the labour cost of assembly in the workshop
• The gross margin is the trading margin minus the cost of having the door delivered to the home by a delivery service (if the customer, for example, fits it themselves or has an intermediary joiner do it) and MINUS any cash discount the customer deducts
• The operating result – profit or loss - or operating margin lies a lot “deeper”, namely at the level of all activities/the whole company: what you have left of turnover after paying all the costs of running the company
• The net result, again profit or loss, is the operating result after interest, after exceptional results and after taxes. That is what remains at the level of the whole company (or all activities as a self-employed person) at the end of the financial year for the manager(s) or shareholder(s) .

Insight into your margins

Insight into margins and profit levels is vital for a company. Suppose a business sells two types of table.

• Table A is sold for € 10.000,- and the trading margin after transport and delivery costs such as protective packaging was € 5.000,-. Then the gross margin or gross return = 5.000 / 10.000 = 0,5 or 50%
• Table B is sold for € 7.000,- and the gross profit was € 4.800,- after delivery costs. Then the gross margin or gross return = 4.750 / 7.000 = 0,675 or, rounded, 68%

The gross profit margin of table B is considerably higher than that of table A, because the cost price of B is lower.

Is it then better to sell table B instead of table A? Specialising in table B will probably lead to economies of scale by producing more B tables at lower cost, so that the cost price of B falls somewhat and the profit rises to e.g. € 5.100,-?

Dangerous reasoning, for two reasons:

• The higher return does not mean more profit, quite the contrary here (€ 250,- less), and the possible economies of scale from specialisation are uncertain
• And what if the market's preference for table B disappears? The (too) strong specialisation in table B would then be the death blow, because others would have taken over the market for table A.

Hence two important pieces of advice:

• As an entrepreneur/company, make sure you constantly and accurately know the cost price of your products
• Consciously develop your own offering on the market with a view to the continuity of your activity.

What is a good profit margin?

The “right” profit margin does not exist, because margins and the resulting returns are sector-specific. A supermarket, for example, can score reasonably with a net profit margin on turnover of 1%, while in the luxury sector a good year yields 18%. Larger accounting firms may have an idea of what is customary in your sector, but it is rather the sector associations that have the appropriate information on this. Anyone who really wants to know can learn a great deal through a benchmark – a comparison of figures – with a few dozen known competitors.