Profit is a key indicator of a company’s long-term viability and success. Understanding your small business’s profitability can help with cost-cutting, pricing, and investment decisions.
Here’s everything you need to know about calculating — and increasing — small business profit.
What is profit?
Profit is simply total revenue minus total expenses. It tells you how much your business earned after costs. Since the primary goal of any business is to earn money, profit is a clear indication of how your company is functioning and performing in the market.
According to Brandon Frazier, Founder and CEO of Mobile Clear Shield, there are four factors that impact a business’s profitability:
- Cost management: Operational costs can add up quickly. Frazier recommends managing inventory, reducing waste, and negotiating better terms with suppliers to keep these costs in check.
- Pricing strategy: It’s important to set prices for products or services that promote profitability. “Understanding the market and customer willingness to pay is key,” Frazier said.
- Customer retention: According to Frazier, building a loyal customer base is often more cost-effective than acquiring first-time customers since repeat buyers tend to spend more over time.
- Market conditions: “Economic trends, competition, and consumer behavior can all impact a business's profitability, [so] staying informed and adaptable is essential,” Frazier explained.
[Read more: Creating a Financial Accounting Report With the Four Basic Statements]
Many companies aren’t profitable when they just start out. But lenders and investors will ask for profitability projections — a forecast of when they can begin to see a return on their investment as the company earns a profit. If you miss your targets, your gross and operating profit can help you see where you need to reduce spending or increase sales. Measure your profit on a quarterly, if not monthly, basis to track your progress.
There are three types of profit that can be found on your company’s income statement: gross profit, operating profit, and net profit.
Gross profit
Gross profit refers to the profit that results after deducting the costs of goods sold (COGS). The cost of goods sold is any expenses associated with creating and selling a product or providing a service. Calculate your company’s gross profit by subtracting COGS from revenue (e.g., sales). Gross profit is a way to isolate your variable costs to understand how efficiently your company is using things like labor and supplies to deliver a product or service.
Operating profit
Operating profit is calculated using the following formula: Gross Profit - Operating Expenses - Depreciation - Amortization. Operating profit provides insight into earnings over a certain period because it excludes profits from other investments and other asset-related metrics that don’t have bearing on what it takes to keep the business running. Compared to gross profit, operating profit is considered a highly accurate indicator of a company’s health.
Net profit
Finally, net profit indicates the total profit after all the company’s expenses have been deducted from its revenues. This is an all-inclusive measurement often referred to as the “bottom line” due to its position on the income statement.
What is profit margin?
There’s another way to get a quick understanding of your company’s profitability, and that’s by calculating profit margin.
Profit and profit margin are highly interconnected but distinct figures: Profit margin shows you what percentage of sales has turned into profit. For instance, if your company reports a 25% profit margin, that means it earned a net income of $0.25 for every dollar of sales generated. Of course, you can express profit margin as gross profit margin, operating profit margin, and net profit margin.
Profit margin helps investors, the board of directors, lenders, and other key business leaders understand the company’s financial health, management's skill, and growth potential. It’s more commonly used because it puts a company’s profit into perspective. It’s easier to compare a company’s profit margin to its peers and competitors than total net profit.
Profit margin can also help you compare your company’s performance with that of your competitors, though the ideal percentage will vary based on your industry. For example, margins are typically less than 10% in the restaurant industry. However, in the consulting world, margins can be 80% or more, and can reach as high as 300%.
[Read more: How These Innovation-Driven Startups Reached an Elusive Milestone: Profitability]
Gross profit is a way to isolate your variable costs to understand how efficiently your company is using things like labor and supplies to deliver a product or service.
How to calculate profit margin
Calculating profit margin can help you better understand your business's financial health, as it reveals how much of your revenue remains after covering expenses.
Gross profit margin
Your gross profit margin can be calculated with the following formula:
Gross Profit Margin = (Revenue - Cost of Goods Sold / Revenue) x 100
Subtract the cost of goods sold (COGS) from total revenue to find the gross profit. Divide the gross profit by total revenue, then multiply by 100 to express it as a percentage. This will show how much revenue is retained after production costs.
Operating profit margin
To calculate your operating profit margin, divide the operating income by revenue and multiply by 100:
Operating Profit Margin = (Operating Income / Revenue) x 100
This metric accounts for all daily operating expenses, including overhead, administrative, and sales costs, while excluding debts and taxes. Overall, it reflects the percentage of revenue remaining after covering necessary business expenses.
Net profit margin
To indicate how effectively your company converts income into profit, calculate the net profit margin:
Net Profit Margin = (Net Revenue* / Total Revenue) x 100
*Net Revenue = Total Revenue - Total Expenses
Subtract total expenses — including COGS, operational costs, taxes, debt payments, and one-time expenses — from total revenue. Divide this net income by total revenue and multiply by 100 to express it as a percentage.
What is profit margin analysis?
Profit margin analysis uses profitability ratios to see how well your business turns sales into profit and what returns you're providing to shareholders. By breaking things down — like which products or locations are pulling their weight — you can spot strengths and weaknesses in how you generate income and manage expenses. Adding qualitative data, like customer feedback and market trends, provides even more context for understanding profitability.
[Read more: 6 Monthly Reports Every Small Business Should Monitor ]
How to increase your small business’s profitability
To increase your small business’s profitability, Frazier recommends a mix of short- and long-term strategies:
Short-term strategies for profitability
For short-term profitability, Frazier recommends implementing promotions and discounts to quickly drive sales. He also noted that streamlining operations by eliminating inefficiencies can help reduce costs, and focusing on high-margin products allows you to maximize profit from your best offerings.
Long-term strategies for profitability
According to Frazier, the following strategies create a solid foundation for sustained growth and profitability:
- Investing in technology: By automating processes and leveraging data analytics, you can improve your efficiency and decision-making, supporting your business’s growth and profitability.
- Building a strong brand: Establishing a recognizable brand can lead to customer loyalty, which translates to higher sales.
- Diversifying your product or service line: This can help mitigate risks from market fluctuations and keep your profit margin high.
Additional small business profitability tips
To further improve profitability and overall business success, Frazier advised new and growing small businesses to prioritize the following aspects of their business:
- Financial planning: Regularly reviewing financial statements and creating budgets to monitor spending and revenue can help you identify areas for improvement.
- Networking: Cultivating relationships with other business owners and entrepreneurs can open up new opportunities and provide access to shared resources.
- Customer feedback: Keeping open lines of communication and seeking feedback from consumers can help you gain insight into their needs and preferences, shaping your product development and marketing strategies in the process.
Emily Heaslip contributed to this article.
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