Profit margin is a financial ratio that measures the percentage of profit earned by a company in relation to its revenue. Expressed as a percentage, it indicates how much profit the company makes for every dollar of revenue generated. Profit margin is important because this percentage provides a comprehensive picture of the operating efficiency of a business or an industry. All margin changes provide useful indicators for assessing growth potential, investment viability and the financial stability of a company relative to its competitors. Maintaining a healthy profit margin will help to ensure the financial success of a business, which will improve its ability to obtain loans.
Profit margin is calculated with selling price (or revenue) taken as base times 100. It is the percentage of selling price that is turned into profit, whereas "profit percentage" or "markup" is the percentage of cost price that one gets as profit on top of cost price. While selling something one should know what percentage of profit one will get on a particular investment, so companies calculate profit percentage to find the ratio of profit to cost.
The profit margin is used mostly for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses' operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure, so that comparison of one with another can have little meaning. A low profit margin indicates a low margin of safety: higher risk that a decline in sales will erase profits and result in a net loss, or a negative margin.
Profit margin is an indicator of a company's pricing strategies and how well it controls costs. Differences in competitive strategy and product mix cause the profit margin to vary among different companies.
- If an investor makes $10 revenue and it cost them $1 to earn it, when they take their cost away they are left with 90% margin. They made 900% profit on their $1 investment.
- If an investor makes $10 revenue and it cost them $5 to earn it, when they take their cost away they are left with 50% margin. They made 100% profit on their $5 investment.
- If an investor makes $10 revenue and it cost them $9 to earn it, when they take their cost away they are left with 10% margin. They made 11.11% profit on their $9 investment.
On the other hand, profit percentage is calculated with cost taken as base:
Suppose that something is bought for $40 and sold for $100.
- Cost = $40
- Revenue = $100
- (profit divided by cost).
If the revenue is the same as the cost, profit percentage is 0%. The result above or below 100% can be calculated as the percentage of return on investment. In this example, the return on investment is a multiple of 1.5 of the investment, corresponding to a 150% gain.
Type of profit margin
Gross profit margin
Gross profit margin is calculated as gross profit divided by net sales (percentage). Gross profit is calculated by deducting the cost of goods sold (COGS)—that is, all the direct costs—from the revenue. This margin compares revenue to variable cost. Service companies, such as law firms, can use the cost of revenue (the total cost to achieve a sale) instead of the cost of goods sold (COGS). It is calculated as:
Example. If a company takes in a revenue of $1,000,000 and $600,000 in COGS. Gross profit is $400,000, and gross profit margin is (400,000 /. 1,000,000) x 100 = 40%.
Operating profit margin
Operating profit margin includes the cost of goods sold and is the earning before interest and taxes (EBIT) known as operating income divided by revenue. The COGS formula is the same across most industries, but what is included in each of the elements can vary for each. It should be calculated as:
Example. If a company has $1,000,000 in revenue, $600,000 in COGS, and $200,000 in operating expenses. Operating profit is $200,000, and operating profit margin is (200,000 / 1,000,000) x 100 = 20%.
Net profit margin
Net profit margin is net profit divided by revenue. Net profit is calculated as revenue minus all expenses from total sales.
Example. A company has $1,000,000 in revenue, $600,000 in COGS, $200,000 in operating expenses, and $50,000 in taxes. Net profit is $150,000, and net profit margin is (150,000 / 1,000,000) x 100 = 15%.
Importance of profit margin
Profit margin in an economy reflects the profitability of any business and enables relative comparisons between small and large businesses. It is a standard measure to evaluate the potential and capacity of a business in generating profits. These margins help business determine their pricing strategies for goods and services. The pricing is influenced by the cost of their products and the expected profit margin. pricing errors which create cash flow challenges can be detected using profit margin concept and prevent potential challenges and losses in an entity.
Profit margin is also used by businesses and companies to study the seasonal patterns and changes in the performance and further detect operational challenges. For example, a negative or zero profit margin indicates that the sales of a business does not suffice or it is failing to manage its expenses. This encourages business owners to identify the areas which inhibit growth such as inventory accumulation, under-utilized resources or high cost of production.
Profit margins are important whilst seeking credit and is often used as collateral. They are important to investors who base their predictions on many factors, one of which is the profit margin. It is used to compare between companies and influences the decision of investment in a particular venture. To attract investors, a high profit margin is preferred while comparing with similar businesses.
Uses of Profit Margin in Business
Profit margins can be used to assess a company's financial performance over time. By comparing profit margins over time, investors and analysts can assess whether a company's profitability is improving or deteriorating. This information can be used to make informed investment decisions.
Profit margins are a useful tool for comparing the profitability of different companies in the same industry. By comparing the profitability of similar companies, investors can determine which companies are more profitable and therefore potentially more attractive investment opportunities.
Profit margins can also be used to assess a company's pricing strategy. By analysing the profitability of different products and services, companies can determine which products or services are most profitable and adjust their pricing accordingly. This can help companies maximise profitability and remain competitive in the marketplace.
Margins can also be used to identify areas of a company's operations that may be inefficient or not cost effective. By analysing the profitability of different product lines, companies can identify areas where costs are too high in relation to the profits generated. This information can then be used to optimise operations and reduce costs.
- Earnings before interest and taxes
- Earnings before interest, taxes, depreciation, and amortization
- Gross profit margin
- Net income
- Operating profit margin