What are profit margins and how do you improve them?

February 05, 2023
What are profit margins and how do you improve them?

If you’re an eCommerce business owner you’ve probably come across the term profit margin. When you’re just starting out, it can be difficult to keep up with the industry jargon flying around. This guide will help you understand what an eCommerce profit margin is and how to improve yours, so you can manage your business with confidence.

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ECommerce businesses that are just starting up or struggling to manage their budget may not have the tools needed to understand profit margins. Don’t worry, you’re not alone. There are several companies that were in operation for years and still failed due to lack of proper budgeting knowledge. It’s a lot of work, especially if you’re running a company by yourself. With that in mind, we’ve created this digestible guide, so you can finally understand the term eCommerce profit margin, and take the right steps to increase your own numbers.

This article will cover:

What Is A Profit Margin?

A profit margin is the amount of funds you have left over after expenses have been deducted. It’s the money you can reinvest in your business, whether that be increasing the advertising budget or simply holding onto it for a rainy day. A profit margin tells you exactly how your company is doing, health-wise. With that said, every business’s ideal profit margin is different. Business goals vary significantly for each company. A company could consider $1 a great profit margin, as their goal may simply be to avoid ending up in the negative. Another business might aim for a minimum profit margin of $5,000 as their goal is to grow and expand.

Levels Of Profit Margins

Each business runs their operations differently. Some like to calculate profit margins weekly or monthly; this will largely depend on your size. However, keep in mind that most companies need to report the numbers quarterly for tax purposes, so it does need to be done regularly. You may even need to present it to banks or lenders if you’ve borrowed money from them or plan to do so in the future. In order for this to happen, you will need to know the ins and outs of your business. There are four levels of profit margins that stand out.

1. Gross Profit Margin

To get your gross profit margin you need to subtract expenses from your cost of goods sold (COGS). This is the number before other expenses are deducted, such as shipping costs or warehouse fees. This number offers a big picture of your operations and useful insight into your company’s health. A satisfactory gross profit margin should be between 50-70%. The formula to use would be Gross Profit Margin = (Net Sales – COGS) ÷ Net Sales. Each business operates in highly different conditions so their numbers are certain to vary. If, for example, you’re selling services, then the COGS would be the cost of labor and supplies.

2. Operating Profit Margin

The operating profit margin is what a business earns before taxes and interest are deducted. One subtracts the operating expenses from the total revenue. The final number determines if a business can pay its debt. To get it we use the following formula: Operating Profit Margin = (Operating Income ÷ Revenue) x 100. Knowing this number is vital if you want your business to succeed with its goals. If you don’t like the figures you are getting you can always adjust costs or reduce expenses. That is ultimately the purpose of these formulas, after all. A business can’t improve its operations if it doesn’t know where to look, and the operating profit margin is meant to help with that.

3. Pretax Profit Margin

This calculation is very similar to the operating profit margin formula, except it involves subtracting the interest expenses and including interest income. It goes like this: Pretax Profit Margin = (Profit Before Tax ÷ Net Sales) x 100. As you can see, each step reduces your overall profit margin, as there are more and more expenses to calculate. The steps may seem tedious, but it’s a good method for determining what costs are unnecessary and where you can increase revenue. For example, from your pretax profit margin, you can assess whether you should refinance a loan that has an overly high interest rate.

4. Net Profit Margin

This number will always be less than your other profit margins because it’s a more clear look into how well your company is really doing. More costs will be calculated, leaving less money for you to play with. Net profit margin deducts COGS, operating expenses, interest, and taxes from your total revenue. You’ll calculate it like this: Net Profit Margin = (Revenue – COGS – Operating Expenses – Other Expenses − Interest – Taxes ÷ Revenue) x 100 or Net Profit Margin = (Net Income ÷ Revenue) x 100. So, make sure that you have each variable listed accurately, as it makes a huge difference in the final outcome.

Why Are Profit Margins Important?

As you may have guessed, all these stages of profit margins are helpful when determining how much capital you have to spend or put aside as a company. It’s the best way to understand if errors or insufficient budgeting strategies are weighing down a business and stopping it from reaching its full potential. You should constantly review your budget with close attention to detail so you can stay in line with your growth plan and make tweaks due to mistakes or changes in the market. Expenses can increase on a whim, meaning your profit margin will change, too. Rent can rise, manufacturers can switch to higher quality materials, or shipping costs can increase. There are countless variables to consider, and only your profit margin can tell you where you stand with all the changes that inevitably come with owning an eCommerce business.

A company’s profit margin isn’t only important to you, the business owner, it’s important to banks, lenders, and investors. They need to know this figure in order to determine your company’s worth and estimate the risk of providing you with capital. If your profit margins are low, you’ll have a hard time convincing others to invest, especially traditional banks. You may have more luck with lenders, but you’ll be risking a higher interest rate, which will eat into that already-low profit margin. However, if you can afford it and you believe it will help take your company to the next level, go for it.

What Is A Good ECommerce Profit Margin?

You may be wondering, “What is a good profit margin for my business?” The answer isn’t the same for everyone. Keep in mind that each industry has a different criteria for healthy profit margins. The average for restaurants, for example, is less than 10%. Businesses that offer consulting services can see profit margins as high as 80% to 100%. In the end, the number for each individual business will vary depending on their operations and expenses.

The kinds of goods a business sells can also have a huge impact on this. A 2017 study conducted by the Wall Street Journal and Onestop Internet Inc. found that the profit margins of traditional brick-and-mortar retailers selling high-end clothing stood at 16%. On the other hand, eCommerce stores selling the same products saw profit margins of 30%, almost twice as much. So the type of goods and variation in price and production expenses have a huge impact on a company’s profit margins.

If your profit margin ranks highly among your specific industry you may want to use that money to invest in new products or simply double down on the things that are already working. If you’re struggling to create brand awareness, investing in your advertising budget might be a great option. Are you selling great products? Use that profit margin to stock up on those goods, so you don’t have to worry about falling behind on inventory and facing the prospect of a stockout.

What Is A Bad ECommerce Profit Margin?

The profit margin of a company is primarily determined by its industry and budget management. A bad profit margin is lower than that of competitors. It’s important to do research about industry standards before judging your profit margins. Even if they seem low, they may simply reflect the kind of business you’re in. If your initial predicted profit margin was significantly higher than what it turned out to be in reality, you need to take a deeper look at your business. There may be issues you can iron out in order to increase your earnings. If that’s not possible, perhaps it’s time to switch to another product or industry.

If your profit margins fall noticeably below the industry average, you should address it as soon as possible. Few small eCommerce retailers can afford low profits over a long period, especially since it means they are falling behind the competition, especially in terms of having profits that can be reinvested. Cutting corners on any logistical expenses like rent or internet bills is a no-go as it will quickly lead to your company being unable to function.

How Do You Calculate Profit Margins?

We’ve discussed the many levels of profit margins, but it’s time to talk about the figures that you need to include in the formulas that were listed above. Each unit, such as COGS and revenue, needs to be accurately recorded. Expenses that include rent, utilities, payroll, and inventory need to have precise records, or else your profit margin formula will be inaccurate. Any changes in prices or even a fluctuation in a loan’s interest need to be accounted for. This may seem like an obvious thing to do, but a lot of businesses have failed due to poor record-keeping. Be thorough in all your documentation, and it will boost your ability to oversee your company’s financial health.

In order to keep accurate records, you need reliable budgeting software. Doing everything manually can work, but when you’re an eCommerce business that is working with several partners, such as suppliers, lenders, customers, and employees, automation is the best option. It will help you reduce the human errors that traditional bookkeeping is often riddled with. More than anything, such programs make this process more smooth and intuitive, in addition to providing insights into your business you might not have had otherwise. Most budgeting tools require a subscription but this is a worthwhile investment for almost any eCommerce retailer.

How Do You Improve Your Profit Margin?

Now that you have a better idea of what a profit margin is and how understanding it benefits your business, you should learn how to increase this figure. Higher profit margins give you the ability to expand your operations, improve current processes and make your company more successful. You can boost your budget for things like marketing or software, or invest in a product that is selling well already. With that said, let’s delve into the best ways to improve your profit margins.

1. Increase Prices

Raising prices is a straightforward way to increase a company’s profit margins. Good inventory software can provide insight into production and shipping costs, and how much you are making in profits for specific products. You should factor in these metrics before increasing prices. However, it is very important to consider market trends before making any major changes. If, for example, the economy and consumer spending are in decline, you’re unlikely to increase sales numbers since people would be prone to tighten their budgets. Also, raising prices on products that aren’t selling a lot currently is not advisable unless you are very confident about their sales increasing anyway, for example, if you have a big ad campaign planned.

Now, raising prices may work if everything goes according to plan, but keep in mind that the customer may not take it well. Trust is essential in building your own community. If you raise prices too much, people won’t just quietly shop somewhere else, they might even go out of their way to leave bad reviews. So, it’s best to choose a few items to start with and raise costs gradually over time. You don’t want to shock your customers. Ideally, any price changes would go nearly entirely unnoticed by customers, so you can keep your positive relationship with them. At the end of the day, beyond facts and figures, it’s extremely important to pay attention to how customers feel about your brand and the decisions you make.

2. Lower Your COGS

The cost of goods sold or COGS is another piece of the puzzle that often gets overlooked. There are always ways to reduce production, shipping, and inventory costs. One option is to start a discussion regarding the conditions of the current deal you have with your supplier.

Before you initiate this talk, look into other suppliers and get a solid understanding of the pricing options and perks on offer. This will give you a better bargaining hand in negotiations. Then, discuss processes or services that can be improved or prices that can be brought down. Ordering bigger or more frequent batches or offering to make payments upfront can be reliable strategies to get a better deal. Just like you want reliable suppliers, they want reliable customers. Leverage the fact that you’ve been in business with them for a long time as it is something they surely value. And finally, if you can’t improve your deal sufficiently, go with another supplier that suits you better.

Alternatively, it may be worth considering adopting the Just In Time Inventory (JIT) strategy. It entails only keeping enough inventory on hand to fulfill orders. Without overstocking and unproductive storage fees, you’ll be able to spend that money elsewhere or put it aside. The JIT method can trim a lot of costs, but it’s not great if your business is highly susceptible to market trends or generally requires quick adaptability. It poses the risk of income losses when delays and unexpected sales spikes emerge and you don’t have enough inventory to meet demand.

3. Raise Average Order Value

Shipping items individually and holding them in warehouses for extended periods can cause unnecessary costs. Raising your average order value means that you can reduce both of these expenses. Some ways to achieve this include bundle deals or offering free shipping for large orders. More items sold means less warehouse holding time for your products. More items in an order means cheaper shipping as well. Your customers will feel like they got a great deal, which they did, and you will reap the benefits of a higher average order value.

It’s easy to bundle items and offer free shipping, but it’s also important to watch which items you’re doing this for. High-priced items shouldn’t be bundled as they tend to offer large enough profit margins to cover shipping on their own. Heavy items cost more to transport, so be wary when offering discounted or free shipping. It may end up not being cost-effective, depending on where the order is being shipped. So, play around with your budget and see where the numbers land. Check in with your shipping partner too, as they can provide better insight into shipping fees.

4. Reduce Waste

The best way to increase profit margin is to reduce unnecessary expenses. Talk with your shipping partner about better shipping routes. A shorter or more efficient transport route might mean cheaper shipping costs. Look over your inventory and get rid of anything that isn’t selling well or has outlived its lifecycle. When you focus on stocking things that sell better, your revenue will automatically increase. If your business is small, instead of paying for warehouse space, check on other storage methods. If you have small enough inventory and package everything yourself anyway, a storage unit or even your basement might be more cost-effective options.

It may be a difficult confrontation, but looking over your staff may also be a way to reduce waste. Positions can outlive their usefulness as your business grows and people become lax in their jobs. Letting certain employees go can mean less expenses and more revenue. If you’ve invested in stocks, you need to keep a close eye on them if you haven’t hired someone to do so. The economy is in a particularly volatile period so you’ll want to make sure that your gains aren’t eliminated by market trends that you didn’t notice in time. It is always wise to look over your regular expenses, such as business loans. If you’re in a better financial place now it might be a good time to refinance certain loans. Lower long-term interest rates can noticeably boost your profit margins.

5. Break-Even Analysis

Performing a break-even analysis can help you determine what changes might help your business perform better. It means comparing your costs with your income and provides insight into the cause and effect of things, such as lost shipments, damaged inventory, and returns, all of which affect your bottom line. With a good understanding of these factors it will be more straightforward to take preventative measures and avoid unnecessary hiccups.

Choosing a better shipping partner may help with lost shipments and damaged inventory. Speaking with your manufacturer about improving the packaging of your products can help reduce damage during transport as well. Returns can be avoided by making sure your product descriptions are on point. More often than not, returns are made due to a miscommunication about the product itself.

Completing your break-even analysis can give you a better understanding of how to reach your goals. It will help you determine pricing and the amount of inventory you need to keep stocked. The figure will be the deciding factor in your business strategies. For example, if you see that inventory and logistics costs are holding you back too much, you might want to switch to a drop shipping business model, which is where your supplier handles the production, money exchange, and shipping to your customer, while you earn the difference of the product’s wholesale and retail price.

6. Diversify Channels

Diversifying your sales channels is a reliable way to increase your profit margins. This means expanding to alternative platforms you’re not on already, such as eBay, Amazon, Walmart or Shopify. You can use these channels to reach larger and more diverse audiences. This is good for appealing to a larger clientele but it also gives you insight into what sales channels and customer groups your products perform the best with. You may even want to try opening a physical store as well. The more people you reach, the higher the chances for sales. This is also true for advertising, but let’s discuss some of the side effects that come with this method.

Maintaining multiple channels, especially if you’re the sole person running your business or just starting up, can be overwhelming and may reduce your chances of success. Customers can tell when you’re stretched too thin. This comes in the form of poor customer service, such as late deliveries, failure to respond to inquiries, and mistakes during money exchange. If you don’t have the energy or resources to handle expansions, then target areas and customers who are more likely to be drawn to your niche. This can be determined through surveys, reviews, and social media conversations. When in doubt, start small, and grow your business as you learn more about your unique industry.

7. Start A Loyalty Program

Having lots of customers is great, but it’s even better when you can make them come back. How? You build a relationship with them. They need to trust you. A great way to build trust is to create a loyalty program. People love rewards, and if they earn points or discounts from shopping at your store, they’re more likely to return. You can even bring in more customers by offering referral discounts. Your current customer gets a treat for bringing their friend into the fold, which is something we can all appreciate. It’s a win-win for everyone.

It’s all in good fun to offer discounts, but if the product isn’t what they expected, then the tides can turn quickly. You need to make sure you sell quality goods and are sufficiently transparent with their descriptions. Word-of-mouth is powerful, and if one person spreads the word that you’re selling cheap goods at high prices, you’ll miss the opportunity to gain new customers and might even lose old ones. When in doubt, be honest. It’s much safer than the risk of frustrating customers.

8. Better Customer Service

Providing quality customer service is a great way to build your brand and increase your profit margins. No matter how great your goods and prices are, people will turn away from you if you treat them poorly. If there was a mistake made on your end, then rectify it, even if it eats into your profits. It’s cheaper to pay for the mistake than to lose all the business that a customer could have given you in the future.

Don’t forget the power of user-friendliness. Your website should be intuitive to navigate and you should be easy to reach. Offer clear pathways to follow when it comes to inventory. Provide an email, phone number, and ideally even live chat, so that customers can ask questions about the products. A Q&A page would also be beneficial, so customers don’t have to wait for your response. In short, create a community and system that you would enjoy being in and using yourself.

A Funding Solution To Boost Your Profit Margin

While the quest to improve your profit margins can take time and effort, there is one straightforward solution with many upsides: seeking growth capital. This means getting important funds that allow you to invest in things your business is doing well, for example, a product that is flying off the shelves faster than you can replenish your inventory. 8fig offers cash infusions for eCommerce sellers with the goal of helping them to build on their current growth. This means everything from ensuring that popular products don’t run out of stock to funding a marketing campaign that can bring in a lot of new customers.

And the best part about 8fig is that your growth plan is tailored to match your store’s performance, meaning your remittance payments happen in line with your earning income from sales. If any disruptions to your supply chain emerge, as is natural in the eCommerce world, you can tweak your growth plan and change your remittance schedule. If you want to read more about the platform, SellerApp wrote this comprehensive 8fig review. Optimize your profit margins by joining 8fig here.

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