What is Profit margin? How to use it?

For a business to survive in the long term it must generate profit. Therefore the net profit margin ratio is one of the key performance indicators for your business. Profit margin is used as a measure of how much a company actually retains in earnings per dollar of revenue from sales of goods or services. It is one potential measuring stick of profitability. The term has various other names, such as net profit margin, net profit ratio, or simply net margin.

Profit margin is simply calculated by finding the net profit as a percentage of the revenue.

Net Profit margin = Net profit (after taxes) / Revenue * 100

A 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Profit margin can be useful for comparing or contrasting companies that are within similar industries, but cross-industry comparison may not be as beneficial as profit margins vary greatly depending upon the involved industry. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. A low profit margin can indicate pricing strategy and/or the impact competition has on margins.

Profit margin can also be helpful as simply looking at earnings may not tell as much of a story. Even increased earnings may not mean the company’s financial situation is improving if costs have increased by the same amount or more. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For instance, if a company has costs that have increased at a greater rate than sales, it leads to a lower profit margin. This is an indication that costs need to be under better control.

Imagine a company has a net income of $10 million from sales of $100 million, giving it a profit margin of 10% ($10 million/$100 million). If in the next year net income rises to $15 million on sales of $200 million, the company’s profit margin would fall to 7.5%. So while the company increased its net income, it has done so with diminishing profit margins.

Here are a few examples of the net profit margins from the same businesses:

Leisure & Hotels International Airline Manufacturer Retailer Discount Airline Refining Pizza Restaurants Accounting Software

Net Profit 7.36% 4.05% -10.48% 1.63% 10.87% 12.63% 7.55% 27.15%

Just like the gross profit margins, the net profit margins also vary from business to business and from industry to industry. When we compare the gross and the net profit margins we can gain a good impression of their non-production and non-direct costs such as administration, marketing and finance costs.

We saw that the international airline’s gross profit margin was the lowest of this group of eight businesses at only 5.62%; but look, its net profit margin is 4.05%, only a little bit lower than its gross profit margin. On the other hand, the discount airline’s gross profit margin is 27.46% but its net profit margin is a lot less than that at 10.87%. As we just said, these comparisons give us a great insight into the cost structure of these businesses.

Look at the software business too, a very high gross profit margin of 89.55% but a net profit margin of 27.15%. This is still high, but we can now see that the administration and similar expenses are very high whilst its cost of sales and operating costs are relatively very low.

It is worth analyzing the ratio over time. A variation in the ratio from year to year may be due to abnormal conditions or expenses. Variations may also indicate cost blowouts which need to be addressed. A decline in the ratio over time may indicate a margin squeeze suggesting that productivity improvements may need to be initiated. In some cases, the costs of such improvements may lead to a further drop in the ratio or even losses before increased profitability is achieved.


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