Profit Margin Definition
Profit margin 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.
- 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 margin, resulting in a 100 percent profit.
- Making $10 on an item that cost $9 would equal a 10 percent profit margin, resulting in an 11.1 percent profit
- Making $10 on an item that cost $10 would equal a 0 percent profit margin, 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 analyse 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.
Other Types of Profit Margins
Many companies look at two additional types of profits margins, gross or net:
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.
Net Profit Margin
Where gross profits margins 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.
A high gross profit margin 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 margin business may show a high net profit margin if there are atypical gains (perhaps asset sales) recorded on the income statement during the reporting period.