Revenue is important. But it can also be a misleading metric when it comes to tracking the financial health of your company. Your gross sales may be very encouraging. But if your operational and non-operating expenses are high, your company may not be profitable, even if its income is very healthy. Therefore, a company needs to track not just its revenues but its profit margins.
The term profit margin refers to several profitability ratios that can be applied to a company’s finances in order to ensure that its income exceeds its outgoings. Different types of profit margin calculations can be used to determine whether the company is making money or whether its operational model is profitable. Net profit margin is the most commonly used, although others include gross profit margin, operating profit margin and pre-tax profit margin.
Profit margins are typically expressed as a percentage. If, for instance, a company earns a net income of 40¢ for every dollar it earns, its profit margin is 40%. Naturally, margins differ greatly between industries. Some industries, like energy and telecoms, with extremely high overhead costs for instance, have inherently slender profit margins and make money through their huge customer volumes. Online retailers and service providers, on the other hand, may have comparatively few overheads and operating costs and therefore their margins will be higher.
Examples of profit margin
Profit margin is an umbrella term encompassing several different types of margin. Each of these is calculated using a slightly different formula and is used to gauge different facets of a company’s financial wellbeing.
Here, we’ll take a look at the most common examples of profit margins, how they are calculated and why they might be used.
Net profit margin
Net profit margin represents a company’s absolute bottom line. It is the revenue that is left over after all the company’s operating and non-operating costs have been paid. The only outgoing figures that are not included are dividends paid to investors, as these are not classed as an expense. Net profit margin is calculated by dividing net profit by net income and multiplying the result by 100 to express it as a percentage.
Gross profit margin
Gross profit margin starts with total sales income and deducts all costs directly associated with bringing the product or service to market (labour costs, raw materials etc.). These are known as cost of goods sold or COGS.
Gross profit margin is useful in determining how cost-effective a company’s processes are in getting goods or services to the customer.
Pre-tax profit margin
Pre-tax profit margin, as the name suggests, accounts for all expenses before taxes are deducted. As well as operating expenses, this takes into account non-recurring expenses, such as the cost of moving to a new location or renovating premises, or losses from discontinued operations.
Operating profit margin
Finally, operating profit margin is used to calculate how efficient a company’s operations are. It is derived by deducting all operating costs (including COGS) from total revenue.
How to calculate profit margin
Profit margin is stated sequentially on a company’s profit and loss account (also known as its income statement). The company records total revenue from sales, then deducts the direct costs associated with delivering the product or service. This gives it the gross margin. Next, it factors in more indirect costs like rent and utilities for a physical premises, sales and marketing costs, and costs from research and development. This gives the company its operating margin. Then it factors in any interest due on loans and other debts as well as factoring any other income or expense not related to core business activities (like selling shares, relocating to a new property, settling lawsuits etc.). This gives the company its pre-tax profit margin. Finally, it pays its taxes, leaving its net profit margin (also referred to as net income).