Profit Margins

The term profit margin refers to the amount of money a company makes after it subtracts the cost of goods sold from the gross revenues.  The profit margin is represented as a ratio for benchmarking purposes.  A company may use the profit margin ratio to compare it against the profit margin from previous periods or for purpose of comparison to a similar company or the industry average. 

The profit margin is calculated by taking profit and dividing it by net sales; however, to dig deeper into the efficiency of a company, profit margins will be calculated using profit figures derived at different levels within the income statement.  Remember, in the income statement, a net profit number is arrived at after subtracting many costs and expenses along the way such as selling, general and administrative costs, tax expenses, labor, etc.  By calculating profit margin at different levels, we are able to more accurately determine the efficiency that exists within various levels of the organization. 

Different Types of Profit Margin Calculations


Let's start with the highest level of profit on the income statement, known as the gross profit.  Gross profit is equal to gross sales minus all the costs directly related to the product or service that was sold.  The bulk of these costs include materials, labor, marketing, manufacturing expenses, and selling costs.

The gross profit margin can be calculated with the following formula:

Gross Profit Margin Formula

This formula will give us an idea of how efficiently the company is managing their core production costs as we discussed above.  The higher the gross profit margin, the better; however, a delineation must be made between production oriented companies and service oriented companies.  Service based companies such as consulting companies do not hold the same level of importance to their gross profit margin as producers do. 

Moving down the income statement, the next rung on the ladder is operating profit.  Operating profit margins are derived from subtracting the companies SG&A expenses from gross profit.  Operating profit margins will allow investors and the board of directors to review management's ability to control costs.

Operating Profit Margin Formula

The net profit margin is commonly referred to as the companies "bottom line", subtracting all expenses, including taxes to arrive at a final number for income.  It is not necessary that a company have a very high net profit margin; in fact, in some industries it is better not to.  With companies such as grocery stores, it is important to move a massive amount of volume.  To do this, grocery stores must reduce their profit margins to as low as possible.  Keep in mind that a high net profit margin does not correlate to large profits.  If the company cannot move their product, it does not matter what the net profit margin is, they are not making  money.  Basically, the net profit margin is telling us how much markup, after all costs and expenses, there is in the companies business model.  It is perfectly acceptable to have a low profit margin with a very fast inventory turnover.

Net Profit Margin Calculation
Tim Ord
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