What is margin?
In the business world, margin is the difference between the price at which a product is sold and the costs associated with making or selling the product (or cost of goods sold). Broadly speaking, a company’s margin is its ratio of profit to revenue. Margin is one of the most important performance metrics for businesses to track. A company can be bringing in enormous revenues, but if it has very high operating costs, its profit margins are likely to be anaemic. When margins are disproportionately low, companies must find ways to reduce costs or boost revenues to the margin which represents a greater percentage of their revenues.
However, while this is the most common definition of margin, there are several others used in the business and financial worlds.
Examples of margin
The meaning of the word depends on the context in which it is used. While the definition above is most often encountered by business owners, there are others used by investors, lenders and traders. Let’s take a look.
Investments and trading
In a trading context, margin is the capital that an investor borrows from a broker to purchase an investment. It represents the difference between the investment’s value and the value of the loan. Investors may use a share trading account through a broker known as margin trading. This is where an investor uses the funds or securities in their account as collateral for a loan. A deposit known as a minimum margin is required in order to open a margin account with a broker.
The practice of margin trading (also known as buying on margin) means borrowing funds from a broker to trade assets. These assets then form the collateral for the loan that is obtained from the broker.
Margins are also seen in mortgage lending. Variable-rate mortgages offer changing rates in line with rising and falling national interest rates. In order to mitigate against loss, lenders will build a margin onto the Reserve Bank of Australia’s cash rate.
Different types of profit margin
In business accounting, there are different types of profit margin which need to be calculated and tracked in order to maintain a clear understanding of the company’s financial health.
A company’s gross profit margin refers to the profits the company makes after variable production costs have been deducted but before fixed costs have been accounted for. It is used to get an understanding of how efficiently the company is using its resources such as materials and personnel.
Net profit margin is calculated by deducting all expenses outside of the cost of goods sold (COGS). There is more than one formula for doing this; however, the simplest way is to start with the net income for the period. This is found on the bottom line of your company’s income statement. Divide this figure by your total revenue and multiply the resulting figure by 100. This gives you your net profit margin as a percentage.
A company’s operating margin tracks how much profit it makes on every pound in revenue after all variable costs are accounted for (including raw materials and employee wages), but before tax has been paid. It is calculated by dividing the company’s operating income by its net sales.
Frequently asked questions about margin
Why is it important to track margin?
Companies may be earning strong revenues, but if their operating costs are high, the business may still be in poor financial health. Therefore, the company can determine its profitability by tracking its gross margin, its net margin and its operating margin.
What is a margin call?
A margin call is a trading scenario where an investor needs to add more collateral to their margin account. A broker will issue a notice to the investor, who will then add more funds to their accounts, selling more securities if necessary to do so.