Profit margin is one of the profitability measures of companies performance. It represents what part of a company’s sales turns into profits. In other words, it indicates a percentage of income from a dollar of sales. For example, when a business announces that it has a profit margin of 30%, it means that the company generates a net income of 0.3 cents from a dollar of sale.
What is the profit margin?
Profit margin is a ratio that calculates the percentage of profit remaining after paying all the expenses. It is one of the most popular measures that investors, creditors, and other stakeholders review to determine a company’s ability to generate profits from sales. For example, creditors use that to ensure that the company is making profits to repay the funds borrowed. On the other hand, investors want to make sure that the company makes enough money to distribute dividends at the end of a period. Internal stakeholders, such as executives and managers, should review expenses when the profit margin is low.
To state it simply, the profit margin is proof of a company’s effective operations.
Types and calculations of profit margins
There are three main levels of profits on a company’s income statement depending on which profit margin you want to calculate. Those are:
- Gross profit
- Operating profit
- Net profit
All three ratios are extremely common and helpful in the financial analysis of a company. Although each ratio takes a different layer of a profit, the calculation logic is the same. You can calculate all those margins by dividing the profit amount by the company’s sales revenue and multiplying by 100 to get the percentage result.
Let’s look deeper into three types of profit margins.
Gross profit margin
As defined by Investopedia, gross profit is the company’s profit after deducting production costs or costs associated with providing the service. In other words, those costs are called COGS or the cost of goods sold.
The cost of goods sold refers to direct expenses of manufacturing processes. It includes costs of raw materials used in production or labor wages directly working on manufacturing the products. GOGS does not include indirect production overheads, taxes and interests paid, fixed costs, etc.
Following are the three main steps you should take to calculate the gross profit margin.
Calculate the gross profit
The formula of gross profit calculation is the following:
Gross profit = sales revenue – (direct materials cost + direct labor cost + factory overhead cost)
If you have the company’s financial statement, the above-listed costs might be represented as one figure as the cost of goods sold under the revenue.
Determining the net sales
You calculate the net sales by following this formula:
Net sales = sales revenue – the cost of sales returns, allowances, and discounts
Calculate the gross profit margin ratio
When you have those two figures under your hand, just divide profit by sales to find the gross profit margin ratio.
Gross profit margin = (gross profit / net sales) x 100%
Operating profit margin
The operating profit margin calculation is a bit more complex than the gross profit margin because it also considers the effect of operating expenses. Operating expenses include administrative and operating costs, such as depreciation, marketing, sales, indirect labor salaries, rents, other utilities, etc. Operating profit is also known as EBIT (earnings before interest and tax) because it takes all business expenses except interests and taxes paid.
The purpose of operating profit margin is to determine a company’s profitability after the business’s operating expenses are made.
Calculate the operating profit
To calculate the operating profit margin, you should first find how much is the operating profit. You can also see that figure calculated on the financial statements of the company.
Operating profit = sales – COGS – operating expenses – depreciation and amortization
Determine the operating profit margin
The following formula calculates the operating profit margin:
Operating profit margin = (operating profit / revenue) x 100%
Net profit margin
The net profit margin gives the most comprehensive profitability image. It shows the net profit that business generates after extracting all expenses. Thus, it provides more accuracy on a company’s ability to generate profit from sales.
There are two steps to determining a company’s net profit margin:
Calculate the net profit
You find this by following this formula:
Net profit = sales revenue – all costs and expenses
If you have the operating profit calculated, just deduct interests and taxes from that figure to get the net profit.
Determine the net profit margin
To get the net profit margin, complete this ratio:
Net profit margin = (net profit / sales revenue) x 100%
Profit margin ratio example
Let’s look at the following practical examples to understand the implementation of those profitability ratios better.
Let’s calculate the company’s profitability ratios for 2020.
Gross profit margin = 880 / 3,980 x 100% = 22.11%
Operating profit margin = 215 / 3,980 x 100% = 0.54%
Net profit margin = 165 / 3,980 x 100% = 0.41%
How to interpret the profit margin results?
So, profit margins determine the percentage of net earnings in a company’s sales. Generally speaking, it is a measurement of the profits generated from sales.
Obviously, companies strive for high-profit margins because it is an indicator of large profits compared to expenses. It is achieved by reducing costs and increasing sales revenues.
You can learn about how to increase sales with multichannel selling here.
Don’t forget to also look at the industry averages before assessing if the profitability ratio results are good or not.
Margin vs. Markup
Markup and margin are different concepts that are sometimes misused. Both of those are for determining expenses and setting prices to generate profits. For example, margin measures a company’s earnings after paying costs.
Markup indicates the difference between your selling price and costs. The higher the markup, the more net income you generate from your sales.
To find a margin, you should divide a profit figure by revenue. To calculate a markup, you should divide gross profit by COGS.
In conclusion
Profit margins are profitability measures that different stakeholders calculate to assess the financial health of the company. Generally speaking, the higher those ratios are, the more profitable a company is.
