Profit margin is a profitability ratio that measures the extent to which a business or company operations make profits. It shows the percentage of sales turned into profits. In other words, the figure shows how much money or profit the company has made for each dollar in sales. For example, a business’s financial statement reads that the firm has made a 25% profit margin, which means that the net income of $ 0.25 for a dollar in sales. 

Types of Profit Margins

There are three types of profit margins. 

  • Net profit margin revenue less all expenses
  • Gross profit margin is the total income less cost of goods (COGS)
  • Operating profit margin- is net income less operating expense and COGS

Net Profit Margin

The net profit margin calculates and expresses its entire profitability rather than just a single service or product. It is expressed in percentage, and a high number denotes that the company is more profitable. A low-profit margin is a sign of a problem affecting the company’s profitability potential, together with management problems, productivity issues, or high expenses.

Calculating net profits require all the company’s costs and revenue, and not just for one product. It is computed by dividing net income by revenue or net profit by net sales gained over time. 

Net Profit Margin = (Net Income / Revenue) * 100

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Example 

A company has a gross sale of $300,000 and expenses $150,000, therefore the net income is $150,000. To get the net profit margin, you divide $150,000 by $300,000 to get 0.50. Multiply 0.50 by 100 to get a 50% profit margin.

One cannot compare profit margin with businesses in two different industries. The characteristics of companies vary so much that you cannot expect, for instance, that a tech company to be comparable to a construction company. 

Gross Profit Margin

It mainly applies to a specific line or product and not the entire business. The gross profit margins would help a company decide on the product pricing because a low gross profit could mean the business needs to implement some changes to the sales of a specific product. 

Gross profit is derived by deducting the cost of goods sold from the total revenue/net sales. Divide the results by the total revenue/net sales, multiplied by 100 to get the percentage ratio. 

Gross Profit = {(Net Sales / total revenue-COGS) / Total Revenue} *100

Example

If a company has a total sales of $15,000 and a cost of goods sold at $10,000, the difference between them is $5,000. Divide the $5,000 by 15,000 and then multiply by 100 to get 33.3%. It will be the company’s gross profit margin. 

The costs of goods sold do not include indirect costs such as office supplies or rent, but the direct product cost.

Operating Profit Margin

The margin includes both costs associated with administrative, selling, overhead, and costs of goods sold. The COGS formula applies across all industries. However, taxes, debts, and other non-operational expenses are not included.

Operating margin = (operating income/ revenue) *100 

Example

If a company’s operating income is $20,000 and the revenue is $60,000.

The operating profit margin will be ($20,000/60,000) * 100

Therefore, the operating profit margin will be 33.3%.

Components of the Profit Margin Formula

  • Cost of goods sold: It includes the total costs used to produce goods and services. It includes labor and materials. 
  • Revenue: It is the total sales made from a company’s products and services. It does not include the operating cost incurred. 
  • Net income/total revenue: it is the total revenue less the expenses. It includes business expenses such as investment tax, general administrative costs, and debt payments. 
  • Net sales: it is gross sales, less allowances, discounts, and returns. Net sales are used to predict revenue accurately.

Importance of Profit Margin

It provides a good insight into different aspects concerning the company’s performance. These include:

  • Company’s pricing strategy, 
  • Company’s competition vs. performance
  • Company’s ability to manage expenses
  • The business stability and profitability
  • The potential of a company to invest. 
  • Two ways a company can attain better profit margins:
  • By lowering the cost while making the same amount of profits
  • Keeping the cost low while generating more revenue

Profit margins should only be used to draw comparisons between companies with the same business model or within the same sector. Cyclical and seasonality sales should be taken into account when comparing profit margins for a specific period.

You can monitor your company’s health by tracking the business profit margin to make better decisions in the future. This can also help you to identify and resolve your business financial issues with ease. A good profit margin attracts more investors to your company.


Chris Douthit
Chris Douthit

Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.