Calculating Net Profit Margin
Calculating a company's net profit margin tells you how much after-tax profit the business keeps for every dollar it generates in revenue or sales. The net profit margin is the calculation that determines the percentage of profit it realizes from overall revenue.
Profit margins can vary by sector and industry, but the implication is the same: the higher a company's net profit margin is compared to its competitors, the better.
Exceptions to the Rule
There are some notable exceptions to this rule, but the that would require getting into a complex analysis of something called the DuPont Return on Equity formula. The short and sweet version is this:
It's possible for a business to make an additional absolute net profit by focusing on lowering its net profit margin and driving sales up as customers are attracted to its stores. Dillard's, the regional mall department store, is an example of this approach. It has a lower net profit margin—1.77% as of Jan. 31, 2020—compared to a retailer such as Walmart, which earned 2.84% as of the same date.
There's an inherent danger in this approach, however, especially when dealing with high-end brands. Lowering prices to drive sales is often called "going downstream." Business can begin to suffer when a retailer has lost status in the mind of the public,
This is why you've never seen—nor are you ever likely to see—a single sale or discount at Tiffany & Company.
How to Calculate Net Profit Margin
Several financial books, sites, and resources tell an investor to take the after-tax net profit divided by sales to calculate net profit margin from a company's income statement.
While this is standard and generally accepted, some analysts prefer to add minority interest back into the equation to give an idea of how much money the company made before paying out to minority owners.
Minority owners are typically people who hold a substantial stake of 20% or less, such as a successful family that sold 80% of its business to Berkshire Hathaway yet retained the remaining stock as a private holding. This was the case with the Blumkin family at Nebraska Furniture Mart.
Doing the Math
Either method of calculating net profit margin calculation is acceptable, although you should be consistent across firms to make an apples-to-apples comparison. All companies should be compared on the same basis.
Each calculation would work like this:
- Option 1: Net income after taxes ÷ revenue = net profit margin
- Option 2: Net income + minority interest + tax-adjusted interest ÷ revenue = net profit margin
Again, lower net profit margins can represent a pricing strategy and aren't necessarily a failure on the part of management. Some businesses, especially retailers, discount hotels, and chain restaurants, are known for their low-cost, high-volume approach.
In other cases, a low net profit margin might represent a price war that's lowering profits. This was the case with the computer industry back in the year 2000. More families were jumping on the personal computer bandwagon, but not all were willing or able to afford premium prices. Sellers slashed prices to lure them in, sometimes even giving their products for free in exchange for advertising.
In 2009, Donna Manufacturing sold 100,000 widgets for $5 each with a cost of goods sold of $2 per unit. The firm had $150,000 in operating expenses and paid $52,500 in income taxes. What is the net profit margin?
Start by finding the revenue or total sales to calculate the answer. Donna's generated a total of $500,000 in revenues if it sold 100,000 widgets at $5 each. The company's cost of goods sold was $2 per widget, and 100,000 widgets at $2 each equal to $200,000 in costs.
- This leaves a gross profit of $300,000 ($500,000 revenue - $200,000 cost of goods sold = $300,000 gross profit).
- Subtracting $150,000 in operating expenses from the $300,000 gross profit leaves us with $150,000 income before taxes.
- Subtracting the tax bill of $52,500, we are left with a net profit of $97,500.
Plugging this information into our net profit margin formula, we get:
- $97,500 net profit ÷ $500,000 revenue = 0.195 net profit margin, or 19.5%
Keep in mind that you'll already have all of the variables calculated for you when you perform this calculation on an actual income statement. Your only job is to put them into the formula.
The answer, 0.195, or 19.5%, is the net profit margin.