What is profit margin?
Profit margin is an accounting metric used to evaluate the profit gained by the business in regard to the revenue. To put it simply, profit margin marks the difference between the revenue and costs of products sold. Speaking of margin, it is necessary to make a distinction between the major subcategories:
- Gross profit margin marks the difference between total revenue and the cost of goods
- Net profit margin is calculated by taking all expenses (e.g. taxes, royalties etc) away from total revenue
- Operating profit margin marks the difference between revenue and operational costs (e.g. logistics, warehousing etc)
If the term ‘profit margin’ is used without any specifications, it most likely refers to gross profit margin. In this text, we’re also going to use it in that way.
Profit margin formula
With a relevant and high-quality data on revenue, gross profit, operating profit, and net income, you can calculate each of the outlined above types of profit margin. Here are the formulas:
Gross Profit Margin
(Gross Profit / Revenue) x100%
Operating Profit Margin
(Operating Profit / Revenue) x100%
Net Profit Margin
(Net Income / Revenue) x 100%
Making a difference between various types of margin is crucial in both strategic planning and operational routine. If one of a retailer’s regional offices uses wrong calculations or misinterprets different types of profit margin, the outcomes might threaten sustainability of the entire business.
For example, in high-end clothing retail, the profit margin might be exceptionally high while the net margin is relatively low compared to the other retail sectors. That’s why it’s so important to make a distinction between different types of margin and calculate each properly.
Retailers margins: when low isn’t bad
After calculations are done, the next thing is to evaluate whether the identified profit margins are actually good. But that’s not easy. The point here is that ‘good’ profit margin rates vary not only across the industries but may also be different for various SKU in the same portfolio.
As we’ve mentioned already, high-end apparel is an example of an industry dealing with high-profit margins. Personal-care products, jewelry or specialty foods retailers also belong to this category. These kinds of retailers may sell the products with a profit margin going beyond 50%. In contrast, the discounters and the large group of web-only marketplaces tend to operate with low margins.
However, low margins should never be misinterpreted as an indicator of an unprofitable business. For more than a decade, Amazon’s annual net margin has never exceeded the point of 5%. At the same time, the retail giant is firmly among the top 5 largest companies in the US by revenue. Another company from the same list is Walmart relying on a business model implying low margins, yet high sales volume.
But even Walmart sells some products with a relatively high-profit margin. Depending on the product lifecycle stage, the role or mission of every SKU on the shelf might be different. For example, Best Price Guarantee products or BPGs have high velocity but low margin as their mission implies inspiring specific shopping trips. In contrast, exclusive range products are traditionally ones with the highest margin in the portfolio. Click below to learn more about SKU changing roles and how technology helps to price them at every lifecycle stage.
Increase retailers profit margins: where to start
Every retailer is eager to maximize profit margins, regardless of whether low or high margin rates dominate across the portfolio. The trick is to maximize the margin and, at the same time, meet customer expectations. There are many ways retailers can increase profit margin. Choosing a particular blend of tools depends on brand positioning, strategic approach, business maturity, and resources available. Let’s look at the most popular means of increasing profit margin:
Narrow the focus. To a large extent, this point stems from the importance of sustainable market positioning. Before plunging into a new market or sales channel, the business should clearly define its positioning. For example, focusing on exclusive range offerings means that high margins should prevail in the assortment. In this case, narrowing the focus would mean increasing the share of high-margin SKUs.
To learn more about market positioning for online retailers and get some practical tips, watch the video below.
Invest in average order value increase. Basket size or average order value (AOV) is a crucial category while evaluating the effectiveness of a retailer's approach to maximize profit margins. Even if you operate products at low margin rates, you can gain a significant uplift by forcing customers to buy more than one SKU per shopping session. Bundle pricing strategy is one of the best means of increasing the average order value. For example, bundling traffic-generating products with ones of exclusive range at a lower price would help to increase significantly the total margin gained from a purchase.
Look at competitors. For some products, like BPGs or KVIs, the market-based pricing approach works best. For these products, increasing margin makes sense only as long as your prices remain more attractive for customers compared to competitors. And that’s why you need to look at the market and consider the trends while setting prices. For such cases, Competera offers a comprehensive market-driven pricing solution helping retailers to both stay competitive and increase market share.
Manage promo campaigns in a smart way. Unsustainable discounts and markdowns are fairly considered to be the margin killers. Of course, effective inventory management helps to mitigate many risks but, in some cases (e.g. apparel retail), seasonal markdowns are just an inevitable part of the business. And that’s where retailers need advanced pricing solutions capable of identifying both implicit and explicit cross-elasticities between products in the portfolio which are then used to calculate optimal discounts. The latter means hitting the stock at the maximum possible margin rates.
Showcase: maximizing gross profit margin with advanced software
Advanced pricing software can be helpful while undertaking each of the outlined above approaches to margin increase. Let's take the markdown optimization as a showcase to see how it works in detail.
So, what is the dominating approach to markdown? In most cases, it implies a 'blanket' discount which means that the discount depth is the same for all SKUs on sale. As a result, margins get diluted, the probability of hitting stock is ambiguous, and a retailer's price perception is undermined.
In contrast, managing markdown campaigns with advanced software, like Competera, implies differentiating discounts at SKU-level (based on cross-elasticities) and optimizing discount sequences based on data-driven predictions on reaching the targeted stock level. As a result, the business gains maximum possible margins with the entire markdown cycle under control.
Click below to get some real numbers from the case study or contact us to find what can Competera offer to your business.