What is a profit margin and why do you need to know it?

1. The basics: what are the components of the price? 

A very simple example: the customer price is built in the same way as a house. In retail, the foundation begins at the purchase price, followed by costs (this will be explained later) and profits. The sum of these items makes up the net price, but here our house is still in a semi-finished state. This is where VAT comes in which is the top of our building, which adds to the net price to get the gross which is the consumer price.

2. Advanced: the margin

To get an accurate picture of your revenue and be able to plan, you need to know the costs in as much detail as possible. Cost is an expense you pay to earn revenue, including overheads, rent, salaries, advertising, taxation, acquisition, replacement of assets, etc. Newly started e-merchants may not always be able to list this item by item, so it’s worth asking an accountant for help right from the start.

A (good) trader, whether working online or offline, sells the products or services at a higher price than they were obtained. This is when the concept of margin comes into play, with which the purchase price increases. For a business to be stable, the margin must cover costs and profits. It depends on the latter how long you stay in the market and what improvements you can make to your company, which is why it is harmful to operate at too low a price.

3. Pro: the profit margin

As mentioned before, you can measure your success by calculating your profit margin. First, we clarify the concept: During the operation of the company, the required margin mass must be provided, in order to do this, we determine the size of the margin in proportion to the purchase price. This percentage is the profit margin.

Simply put, the profit margin tells you how much of the revenue stays with the company, but it also takes into account the cost of serving customers. The two most commonly used types are gross and net. Basically, it can be calculated by dividing the profit by the revenue. Let's check it out!

The gross profit margin

The gross profit margin shows the profit in relation to the cost of production. For example, you pay 15 EUR for the goods, but you sell for 17 EUR, in which case the gross profit is 2 EUR. If you divide this by the total revenue, you get the gross profit margin, in our case, the result is 0.1. Multiply it by a hundred to get the profit margin percentage: 10%.

This value also includes the cost of creating the products. The net profit margin gives a more nuanced picture.

The net profit margin

This type shows how successful you are in gaining profits from revenue. To count this, you must deduct from the sales revenue the cost of the sold goods and other costs necessary for the operation, the tax, the debt repayment. Anything that doesn't stay in your pocket.

Let's have a look at another example. You purchase the products for HUF 8,000, but you pass them on for HUF 10,000, and the additional costs total HUF 1,000. Your net profit is 1000 forints, you divide this by the total income and then multiply it by a hundred. From this comes the net profit margin, which is now 10%.

4. The higher the profit margin, the more profitable the company

It is important to highlight that the profit margin alone does not give a complete picture of how your webshop / company works, but it can give an important indication. If it’s too low, you need to change something, and it’s worth starting with the prices first.

There are quite a few aspects to consider when pricing, but using good software can save you a lot of work. Consider your costs, but keep in mind that you need to make a profit for a successful business! Do you need a guide? Try PriceKit!