Running an ecommerce business is not without its challenges, one of which is simply making enough money to keep the doors open. Many ecommerce businesses don’t make it, while others just about break even or operate at a loss.
That’s why it’s so important to track your profit margin on a continual basis to see where you stand and what steps you should take to keep the business going. This article shows you how easily and simply.
How Do You Calculate Your Profit Margin?
You can calculate your business’s profit margin using a rather simple formula:
Profit Margin = (Total Sales - Total Expenses) / Total Sales
Here is a simple example of how it works:
Let’s assume that your company made $500k in sales last year. After you deduct all of your costs and expenses, such as rent, salaries, cost of goods, etc., you're left with net profits of $100k. Now, all you need to do to calculate your profit margin is to divide net profits by total sales.
$100k / $500k = 0.2, or 20%, as profit margin is typically expressed in percentages.
Understanding Different Types of Profit Margins
When analyzing business performance, it's helpful to understand that there are actually several distinct ways to measure profitability. Each type reveals different insights about your company's financial operations.
Gross Profit Margin
This metric shows the gap between what you earn from sales and what you spend directly on creating your products. The calculation involves subtracting your direct production expenses from total income, then dividing by that same income figure. This percentage tells you how much money remains after covering the immediate costs of making what you sell.
The formula looks like this:
[(Total Revenue - Cost of Goods Sold) / Total Revenue] x 100
Operating Profit Margin
This calculation goes further by including additional business expenses beyond just production costs. It factors in items like facility costs, employee wages, utilities, insurance coverage, and promotional spending. This gives you a clearer picture of actual earnings before taxes come into play.
The formula is:
{[Total Revenue - Cost of Goods Sold - Operating Costs] / Total Revenue} x 100
Net Profit Margin
This represents the most comprehensive view of profitability. It subtracts every single business expense, including production costs, operational overhead, interest obligations, and tax payments, from your total revenue. The resulting figure shows your true bottom-line earnings.
The formula is:
[(Total Revenue - Total Costs) / Total Revenue)] x 100
Why Does Profit Margin Matter?
Your profit margin is a helpful ratio for gauging a company's financial health and profitability. In general, profit margin can provide a decent insight into different aspects of a company's financial performance:
- Profitability and stability
- Ability to manage expenses
- Pricing strategies
- Performance versus competitors
- Investment potential
Low profit margins could suggest a wide array of issues, from the inability to efficiently manage expenses and overheads, to inadequate pricing strategies. It's crucial for businesses to monitor their profit margin closely, to identify areas for improvement and to optimize their earnings.
Interestingly enough, higher revenue doesn't always translate into higher profit margin. If expenses associated with higher sales have increased faster than the revenue, the company can actually end up making less money. That's why keeping the costs low, effectively managing the inventory, and optimizing the pricing strategy for maximum profit is as much a determining factor for healthier profit margin as increased sales.
Essentially, there are only two ways for companies to achieve better profit margins:
- Generate more revenue while keeping the costs low
- Lower the costs while generating the same amount of revenue
Since generating additional revenues is often more difficult, businesses typically experiment with revenue optimization strategies and tend to look for opportunities to cut down on costs and fine-tune their pricing strategy to improve their profit ratio.
Although profit margin can be useful for comparing companies with one another, the comparisons should only be drawn between companies within the same industry and ideally, with similar business models. Seasonality and cyclical sales trends should also be taken into consideration when comparing profit margin over a specific time period.
What Qualifies as a Strong Profit Margin?
The answer to what constitutes a healthy profitability ratio varies significantly based on your specific business circumstances. Different businesses and industries operate with vastly different margin expectations.
Retail businesses typically work with tighter margins than many other sectors. Physical store locations often see margins ranging from half a percent to around four and a half percent. Online retail operations generally achieve somewhat better results, while specialized distribution companies may reach margins approaching six and a half percent.
As a general benchmark, a ten percent net margin is considered moderate, while twenty percent is viewed as strong and five percent as weak. For gross margins specifically, online retailers often target figures around forty-five percent.
When evaluating your own performance, it's most valuable to compare your numbers against businesses operating in your same market category with comparable business structures.
6 Proven Strategies to Boost Your Profit Margins
1. Trim Your Operating Expenses
One of the quickest paths to better margins involves reducing what you spend on running your business day-to-day. The challenge lies in identifying which expenses to cut without harming your operations.
Start by reviewing everything that keeps your business functioning:
- Workforce expenses
- Facility and utility bills
- Employee benefit programs
- Equipment and upkeep charges
- Required permits and licenses
- Insurance policies
Look for areas where technology or automation could reduce workload. Consider which tasks consume excessive time without delivering proportional value. Sometimes eliminating a service that generates minimal returns can free up resources for more profitable activities.
2. Think Beyond Individual Transaction Profits
Many businesses refuse to accept a loss on any single order, even when doing so would preserve a valuable customer relationship. This short-term thinking can damage long-term profitability.
When you proactively solve customer problems, even at a temporary cost, you create memorable experiences that generate loyalty and word-of-mouth promotion. These benefits far exceed the immediate expense.
Consider these customer-first approaches:
- Send replacement items immediately when inexpensive products fail, without requiring returns
- Ship replacements as soon as customers provide return tracking, rather than waiting for warehouse receipt
- Offer expedited shipping at no charge for loyal customers with urgent needs
- Issue partial refunds proactively when customers express disappointment
3. Build Customer Trust
Establishing credibility with potential buyers is essential for converting browsers into customers. When shoppers feel confident in your business, they're more likely to complete purchases.
Focus on these trust-building elements:
- Design a welcoming homepage that creates positive first impressions
- Provide comprehensive product details that answer common questions
- Share your company's story to demonstrate authenticity
- Display customer reviews and testimonials as social proof
- Be completely transparent about all costs and fees
4. Raise Average Purchase Amounts
Increasing how much customers spend per transaction directly improves profitability. Calculate your current average by dividing total revenue by number of orders.
Try these tactics to encourage larger purchases:
- Suggest complementary items during the shopping process
- Recommend products that pair well with cart contents
- Offer incentives for reaching minimum purchase thresholds
- Bundle related products at attractive combined prices
- Promote special offers on higher-margin items
5. Develop a Customer Loyalty Initiative
Retaining existing customers costs far less than acquiring new ones. A well-designed loyalty program encourages repeat purchases and shifts focus from expensive customer acquisition to profitable retention.
Effective programs provide genuine value that shows customers you appreciate their continued business. Rather than heavy discounting, find creative ways to reward frequent buyers that maintain healthy margins while building long-term relationships.
6. Adjust Your Pricing Strategy
Many business owners worry that price increases will drive customers away. However, modest price adjustments can significantly boost profitability, especially when you offer unique value.
Consider this example: If you sell an item for $100 that costs you $80, you earn $20 profit (a 25% margin). Raising the price just 10% to $110 increases your profit to $30, a 50% improvement in your margin.
Even if some customers choose not to buy at the higher price, you may still earn more overall while serving fewer customers and incurring lower service costs.
This approach works best when you have a distinctive offering and deliver clear value. Test different price points to find the optimal balance for your market.
Set Your Business Up for Profit
Tracking your profit margin can help determine what steps you need to take to survive and then scale. The better you understand what’s making you money and what’s hindering costing you, the more set up you are for success. Remember to keep your customer experience intact throughout this process, and that a strong foundation is the most important thing for weathering any economic headwinds that may blow your way.
Profit Margin FAQ
Why Is Calculating Profit Margin Important?
Your profit margin is a critical yardstick for determining the overall financial health of your business. The higher your profit margin, the more efficient your business is at managing costs and setting the right prices.
What Does an Increase in Profit Margin Mean?
A rise in profit margin implies that after deducting costs, your company is earning more money from each client served or product sold. It’s also a signal to audit what’s going right to stack up more best practices and keep that profit margin boost a continuing trend.
How Can You Increase Your Profits?
There are many tactics for increasing profits, and no one-size-fits-all playbook exists for all businesses and industries. That said, you can stop obsessing over your per-order profits, as a loss on something may mean a substantial rise overall. Check your operating costs for unnecessary or inefficient bloat, and see if you can raise your prices just a bit. More importantly, increase your average order value to encourage repeat business, and create better experiences and customer loyalty programs so you can get the most out of the people who patronize your business.