The 3 Types of Profit Margins and What They Tell You
The profit margin is a ratio of a company's profit (sales minus all expenses) divided by its revenue. The profit margin ratio compares profit to sales and tells you how well the company is handling its finances overall. It's always expressed as a percentage.
The net profit margin tells you the profit that can be gained from total sales, the operating profit margin shows the earnings from operating activities, and the gross profit margin is the profit remaining after accounting for the costs of services or goods sold.
How to Calculate Profit Margin
The profit margin formula simply takes the formula for profit and divides it by the revenue. The profit margin formula is:
((Sales - Total Expenses) ÷ Revenue) x 100
Gross profit margin
This margin compares revenue to variable costs. It tells you how much profit each product creates without fixed costs. Variable costs are any costs incurred during a process that can vary with production rates (output). Firms use it to compare product lines, such as auto models or cell phones.
Service companies, such as law firms, can use the cost of revenue (the total cost to achieve a sale) instead of the cost of goods sold (COGS).
Determine the gross profit by:
Revenue - (Direct materials + Direct labor + Factory overhead)
And net sales using:
Revenue - Cost of Sales Returns, Allowances and Discounts
The gross profit margin formula is then:
(Gross Profits ÷ Net Sales) x 100
Operating profit margin
This margin includes both costs of goods sold, costs associated with selling and administration, and overhead. The COGS formula is the same across most industries, but what is included in each of the elements can vary for each. The formula is:
Beginning inventory + Purchases - Ending Inventory
You then add together all of your selling and administrative expenses, and use it with the COGS and revenues in the following formula:
((Revenues + COGS - Selling and Administrative Expenses) ÷ Revenues) x 100
Net profit margin
The net profit margin ratio is the percentage of a business's revenue left after deducting all expenses from total sales, divided by net revenue. Net profit is total revenue minus all expenses:
Total Revenue - (COGS + Depreciation and Amoritization + Interest Expenses + Taxes + Other Expenses)
You then use net profit in the equation:
Net Profit ÷ Total Revenue x 100
This gives you the net profit margin for the company.
This ratio is not a good comparison tool across different industries, because of the different financial structures and costs different industries use.
How the Profit Margin Affects the Economy
The profit margin is critical to a free-market economy driven by capitalism. The margin must be high enough when compared with similar businesses to attract investors. Profit margins, in a way, help determine the supply for a market economy. If a product or service doesn't create a profit, companies will not supply it.
Profit margins are a large reason why companies outsource jobs because U.S. workers are more expensive than workers in other countries. Companies want to sell their products at competitive prices and maintain reasonable margins. To keep sales prices low, they must move jobs to lower-cost workers in Mexico, China, or other foreign countries.
These profit margins may also assist companies in creating pricing strategies for products or services. Companies base their prices on the costs to produce their products and the amount of profit they are trying to turn.
For example, retail stores want to have a 50% gross margin to cover costs of distribution plus return on investment. That margin is called the keystone price. Each entity involved in the process of getting a product to the shelves doubles the price, leading retailers to the 50% gross margin to cover expenses.