Definition
Profit margin, net margin, net profit margin or net profit ratio is a measure of profitability. It is calculated by finding the net profit as a percentage of the revenue.
Profit Margin
The profit margin is a ratio which presents a measure of a business organization’s profitability in order to gauge its financial performance. It may also be referred to as gross profit margin, net profit margin, profit ratio, or net profit ratio. The profit margin is an indicator of risk, and safety in business. For instance, a low profit margin indicates high risk financial transaction, since the company would not have enough savings to fall back on in case of any financial crisis.
How to calculate profit margin
There are various ways to calculate the profit margin depending on what aspect of the company’s sales one is trying to analyze.
Profit margin on a product
Calculating the profit margin on a particular product is done by comparing the net profit with the product’s selling price. The resultant value, when expressed in percentage, is the profit margin. The net profit is calculated by subtracting the cost from the selling price. Following is the calculation method for profit margin expressed in terms of formulas.
Net profit = Selling price – Product Cost
Profit margin (percentage) = (Net profit ÷ Selling price) x 100
The difference between profit margin and markup
Although seemingly similar, profit margin, and markup are two different indicators calculated for entirely separate purposes. There can also be a huge difference between the profit margin, and markup values. The key difference between profit margin, and markup is that a markup is calculated by comparing the net profit to the cost of the product; whereas the profit margin is a product of the comparison between net profit, and the selling price. For instance, if a product costs $10 and is sold at $15, the markup will be 50%, and the profit margin will be 33.33%.
Uses and application
Profit margin is one of the most significant ratios when it comes to assessing how well a business is performing financially. A net profit margin, calculated on all products and services, after subtracting expenses, interests, and taxes provides an accurate measure of the organization’s profitability in the conduct of business. Including expenditures into the equation, also allows for a comparison of the expenditures, and the revenue. Higher expenditures can lead to a lower profit margin.
The profit margin also helps in the analysis of a company’s pricing, and business strategies. Based on the profit margin, and its impact on sales, it is easier to come up with better strategies to ensure continuously improving financial performance.
Further Reading
- Profit margin and capital structure: an empirical relationship – clutejournals.com [PDF]
- Investment income and profit margins in property-liability insurance: Theory and empirical results – www.jstor.org [PDF]
- A diagnostic for earnings management using changes in asset turnover and profit margin – onlinelibrary.wiley.com [PDF]
- Profit margin hedging – academic.oup.com [PDF]
- Alternative measures of profit margin: An empirical study of the potential information content of current cost accounting – www.jstor.org [PDF]
- Profit Margin and Entry: Case Studies of Iron & Steel Industry [J] – en.cnki.com.cn [PDF]
- Relationship between financial leverage and financial performance: Empirical evidence of listed sugar companies of Pakistan – www.journalofbusiness.org [PDF]
