Profit Margin Definition
Profit margin, or profit percentage, is the amount of earnings from sales that exceeds the cost of a service, product or business. The margin of profit is calculated with the base cost of an item and represented as a profit percentage. Profit percentage is equal to net profit divided by the item cost, multiplied by 100 to get a percent value.
Example:
- Making $10 on an item that cost $1 would equal a 90 percent profit margin, resulting in a 900 percent profit.
- Making $10 on an item that cost $5 would equal a 50 percent profit percentage, resulting in a 100 percent profit.
- Making $10 on an item that cost $9 would equal a 10 percent profit percentage, resulting in an 11.1 percent profit
- Making $10 on an item that cost $10 would equal a 0 percent profit percentage, resulting in a 0 percent profit.
The profit margin of a company allows the financial health of the company to be measured. These percentages provide an estimate of profits for businesses to analyze and determine which items or services are making the most for the company. Company leaders can also determine which products or services are costing money because they are selling at a loss or with little to no margin of profit.
See also: how to calculate book value
Before we look at the types of profit margins, we should review some of the key concepts that will be necessary in the next sections.
Margin Vs Profit
Profit is expressed in dollar terms and is the actual cash value. A margin is expressed as a percentage of the revenue or sales. Margin gives a better picture of the profitability as it is normalized for the company sales volume.
Margin = Profit/Revenue (in percentage terms)
Net Vs Gross
Gross is the first profit line in an income statement. This is simply the difference between sales and cost of sales. Of course, this can be viewed at many different levels. You can have gross profit at an item level too. Just deduct the cost of the item from the sales price of the item and you will get the gross profit.
Looking at the gross numbers is a quick way to see how the business is doing at a item detail or business line level. This does not tell you the actual profitability since we have not deducted any of the other expenses of running the business. Once we remove the other expenses, such as personnel, rent, etc., we arrive at the net numbers. Net numbers are easier to calculate at the group of business level as it can be difficult to allocate all the expenses to individual lines.
Markup Vs Margin
You may have heard the term markup to describe the profitability of a product. It is similar to margin but the denominators are different. When you calculate the markup percentage, you divide the profit by the cost of goods sold. Thus for a profitable product, the markup will be higher than the margin. The markup is also know as the ROI or Return on Investment for the product.
Types of Profit Margins
Many companies look at two additional types of profits margins, gross or net:
- Gross Profit Margin
- Operating Profit Margin
- Net Profit Margin
Gross Profit Margin
The gross profit margin is is a narrow look at a company’s profits. By picking specific items in the line of products or services that the company sells, leaders can determine if these individual items or services are profitable. Any product that has a low rate of profit can be phased out and profitable services can then be offered to the customer.
Gross profit margin is calculated using the revenues and the cost of sales line items in the income statement (consolidated or per line of business). The company overhead is not yet part of this calculation.
You can also calculate the gross profit margin at the company level. The gross profit margin is the difference between the net revenue and the cost of goods sold (or cost of sales) as a percentage of net revenue.
Gross Profit Margin = Gross Profit/Net Revenue = (Net Revenue – Cost of Goods Sold)/Net Revenue
Operating Profit Margin
Similar to gross profit margin, operating profit margin is calculated as the difference between the net revenue and the operating costs (also called operating profit or operating income), divided by the net revenue. Using the Operating Profit Margin gives an accurate picture of the business operations – is the management operating the business profitably?
Operating Profit Margin = Operating Profit/Net Revenue = (Net Revenue – Operating Cost)/Net Revenue
Please note that Operating Cost includes all direct and indirect costs of running the business. It however does not include non-operating costs such as taxes and interest. Therefore, the Operating Profit Margin is a good proxy to measure the profitability of the business operations.
Net Profit Margin
Where gross profits percentages are used to determine the profitability of individual products and services, net profits calculate the financial health of the entire company, with the number represented in percentages. The more profit the company has, the higher the percent will be, and the healthier the business. To calculate the net profit margin, you should include the overhead costs as well as other expenses such as depreciation, interest and taxes. The net profit figure is the same as the net income line on an income statement.
Net Profit Margin = Net Profit/Net Revenue – (Net Revenue – Total Expenses)/Net Revenue
A high gross profit percentage does not necessarily mean that a business will have a low net profit. It is entirely possible that a business could have a high gross profit and a low net profit, due to profit loss because of high expenses in areas of employees, rent or other management problems. Similarly, sometimes a low gross profit percentage business may show a high net profit percentage if there are atypical gains (perhaps asset sales) recorded on the income statement during the reporting period.
Analyst Speak: Margin Compression Vs Margin Expansion
Often times you will hear the terms margin compression or margin expansion in the financial media. This refers to the net profit margin either decreasing or increasing over time. Margin expansion can occur if the company is able to increase price while its expenses remain constant. It can also occur when the company is able to lower its expenses through better sourcing, cost cutting measures, economies of scale or scope, or through some other competitive advantages. In this case, the profit margin increases. Margin compression occurs when the company faces increasing expenses but is unable to pass on the increase to the customers by increasing the selling price. It can also occur when there is significant competitive pressure that results in lower price levels. In this case, the profit margin decreases.
Please note that the margin can contract or expand based on changes in any aspect of the expenses. For example, offshoring work for lower employment expenses can help the margin expand. Cheaper raw material cost will also help the margin expand. Margin can expand if the company lowers overall costs through vertical integration. There are many ways for the companies to improve margin.
How to Analyze Margin?
The gross margin is a useful metric to compare different products or lines of businesses within the company to each other. Businesses should consider exiting low gross margin business and doubling down on high gross margin business. This will also help the company improve its product mix and compete against its competitor more effectively.
When you are conducting analysis of the company financial statements, pay attention to the gross margin number and see if it is improving over time. An improving gross margin indicates the management is working hard to improve its product portfolio.
Comparing operating margin or net margin with the competitors in the industry gives an objective look at how well the operations are being managed against the industry benchmarks. A larger number shows that the company has certain competitive advantage that others may not have. A lower number indicates there are areas the company needs to work on to improve their margin.
Importance of Profit Margin for Company and for Investors
The profit margin is one of the key metrics for both the company and the investors looking to analyze the company financial statements. Public businesses exist to generate profit for the shareholders. Therefore it is of paramount interest to both the company and the investors to ensure that the profit margin is being maximized. If this is not the case, there should be remedial actions undertaken to fix the problem.
Profit margin is not an accounting construct. It is a real tangible metric that management is evaluated on.
Margin Summary
Often times we get caught up in the rat race to increase revenue. We may also see increasing profit as the revenue rises, but calculating the profit margin gives us the real picture of whether there are issues in the business that needs to be addressed.
As an investor, the profit margin should be one of the first metric you should review.
Also read: how to calculate profit margin
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