When it comes to performance and profits, every small business should make use of several financial formulas in order to calculate information about key metrics, such as sales generation, inventory, and investments. Understanding and knowing how and when to calculate these key metrics will give you insight into how efficient, effective, and profitable your company is. Knowing this will give you the opportunity to make changes to your marketing strategies and overall business plan. There are two main formulas you want to use when calculating profit, which we will break down into margins and return on investments.
What Is Margin & It’s Associated Formula(s)?
When we think of margin, we commonly think of profit margins, since this is the most widely used financial ratio when it comes to business finance. The margins you want to look at for calculating a small business’s profit is gross profit, operating profit, and net profit. Gross profit is the easiest to calculate, while net profit is the most comprehensive.
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Gross Profit Margins: this formula is the simplest to calculate because it defines profit as all income that remains after accounting for the cost of goods sold. This means that it only looks at the income that remains after costs from the production and manufacturing of that good (raw materials, labor wages) are taken off. The formula for this is Net Sales - Cost of Goods Sold / Net Sales. This formula does not take into account overhead costs, operating costs, debt, or taxes.
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Operating Profit Margins: this formula excludes debts, taxes, and non-operational expenses but it does account for overhead, administrative expenses, and sales expenses in running day-to-day operations. The formula for this is Operating Income/Revenue X 100. When you divide operating profit by revenue, you get a percentage reflected of each dollar that remains after necessary expenses are removed for daily operating costs.
- Net Profit Margins: this formula is the best for reflecting the total amount of revenue that is left over after all expenses and additional income is accounted for. This includes costs of goods per sale, operational expenses, debt, taxes, one-time expenses and payments. It also includes income from investments or secondary sources of income. The formula for net profit margin is (Net income/Revenue) X 100. The long form of this is Net Profit Margin = (Revenue - Cost of Goods Sold - Operating Expenses - Other Expenses - Interest - Taxes/Revenue) X 100.
What Is ROI & It’s Formula?
A return on investment (ROI) is the financial benefit you gain from a business investment. When you calculate this, it measures out what you should get back compared to what you put into the initial investment. It is important to know how to calculate ROI as it will tell you whether a certain business decision is paying off and if it isn’t, it can help you make changes to your business. Typically, an ROI will be represented by a ratio or a percentage depending on what you are measuring it against.
The formula for calculating ROI is ROI = net benefits/total cost. To give a super easy example of ROI, let’s say you spend $10,000 this month on inventory for your small business, and you saw 16,000 in sales. Your profits here would be $6,000 ($16,000 - $10,000) and your ROI would be $6,000 (profits) / 10,000 (cost) = 0.60 or 60%. This means that for every dollar spent, you earned 60 cents in profit.
How Are Profit Margins & ROI Different From One Another?
The main difference between these two is that your profit margin is never going to exceed that 100% value while your return on investment can. Both are great ways of calculating profit but neither is better than the other.
What Is The Value in Monitoring These?
For small business owners, measuring your profit margins is critical as it will provide insight into future growth, investment potential, and weaknesses in your business’s operational model. It helps determine how well your company is doing at generating profits and it can be used to compare against competitors’ in the same industry. As for ROI, it is important to monitor this metric as it can be used to help you clearly see the financial benefit from particular purchases. It can also help you determine if an alternative route provides better cost reductions or better avenues for generating more revenue.