What is a ‘Profit Margin’
Profit margin is a profitability ratios calculated as net income divided by revenue, or net profits divided by sales. Net income or net profit may be determined by subtracting all of a company’s expenses, including operating costs, material costs (including raw materials) and tax costs, from its total revenue. Profit margins are expressed as a percentage and, in effect, measure how much out of every dollar of sales a company actually keeps in earnings. A 20% profit margin, then, means the company has a net income of $0.20 for each dollar of total revenue earned.
While there are a few different kinds of profit margins – including “gross profit margin,” “operating margin,” (or “operating profit margin”) “pretax profit margin,” and “net margin” (or “net profit margin”) – the term “profit margin” is also often used simply to refer to net margin. The method of calculating profit margin when the term is used in this way can be represented with the following formula:
Profit Margin = Net Income / Net Sales (revenue)
Other types of profit margins have different ways of calculating net income so as to break down a company’s earnings in different ways and for different purposes.
Profit margin is similar but distinct from the term “profit percentage,” which divides net profit on sales by the cost of goods sold to help determine the amount of profit a company makes on selling its goods, rather than the amount of profit a company is making relative to its total expenditures.
BREAKING DOWN ‘Profit Margin’
Rarely can a company’s individual numbers (like revenue or expenditures) indicate much about the company’s profitability, and looking at the earnings of a company often doesn’t tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For example, suppose Company A’s revenue for one year is $1 million, and its total expenditures are $750,000. This would yield a profit margin of 25% ($1M – $0.75M / $1M = $0.25M / $1M = 0.25 = 25%). If, during the following year, its revenue increases to $1.25 million, and expenditures increase to $1 million, its profit margin is then 20% ($1.25M – $1M / $1.25M = $0.25M / $1.25M = 0.20 = 20%). Although revenue has increased, Company A’s profit margin has diminished as expenses have increased at a faster rate than revenue.
In the same way, an increase or decrease in a company’s expenditures does not necessarily indicate that the company’s profit margin is improving or worsening. Suppose that Company B’s revenue and expenditures in one year are $2 million and $1.5 million, respectively, making its profit margin 25%. The following year the company does some restructuring, reducing its expenditures by eliminating a product line, and thereby reducing total revenue. If Company B’s revenue and expenditures in the second year are now $1.5 million and $1.2 million, respectively, then its profit margin is now 20%. Even though Company B was able to substantially cut its costs, its profit margin suffered because its revenue decreased more quickly than its expenditures did.
Uses of Profit Margin
On a rudimentary level, a low profit margin can be interpreted as indicating that a company’s profitability is not very secure. If a company with a low profit margin experiences a decline in sales, its profit margin will decline even further, leading to a very low, neutral, or even negative profit margin.
Low profit margins may also reveal certain things about the industry in which a company operates or about broader economic conditions. For example, if a company’s profit margin is low, it may indicate that it has lower sales than other companies in the industry (a low market share) or that the industry in which the company operates is itself suffering, perhaps because of waning consumer interest (or increasing popularity and/or availability of alternatives). This could also result from hard economic times or recession.
Profit margin may also indicate certain things about a company’s ability to manage its expenses. High expenditures relative to revenue (i.e. a low profit margin) may indicate that a company is struggling to keep its costs low, perhaps due to management problems. This is an indication that costs need to be under better control. High expenditures may occur for many reasons, including that the company has too much inventory (relative to its sales), that it has too many employees, and that it is operating in spaces that are too large and thus is paying too much in rent. On the other hand, a higher profit margin indicates a more profitable company that has better control over its costs, compared with its competitors.
Profit margin can also illuminate certain aspects of a company’s pricing strategy. For example, a low profit margin may indicate that a company is underpricing? its goods.
Limitations of Profit Margin
Although profit margin is a helpful and popular ratio for gauging a company’s profitability, like any financial metric or ratio, it comes with certain accompanying limitations.
While profit margin can be very useful for comparing companies, one should only use profit margin to compare companies within the same industry, and ideally with similar business models. Companies in different industries may often have wildly different business models and revenue streams, such that they may also have very different profit margins. This could render a comparison generally meaningless.
For example, a company selling luxury goods may often have a high profit percentage on its wares, while having a low inventory and relatively low overhead, earning modest revenue while maintaining a high profit margin. A consumer staples producer, on the other hand, may have a low profit percentage while having a high inventory and a relatively high overhead, due to a need for a larger work force and more space. The consumer staples company, then, could have very high revenue while having a relatively low profit margin.
Profit margin is also not very useful when considering companies that are losing money, since they have no profit.
Variations of Profit Margin
There are a few variations on profit margin that investors and analysts use to measure more (or less) specific elements of a company’s profit.
One such variation is gross profit margin, which divides gross profit (revenue minus the cost of goods sold including labor, materials and overhead) by revenue earned. This variation comes with certain limitations, such as that management may often have little control over the cost of materials. In this case gross profit margin is less useful for determining management quality. In addition, industries with no production process have no or little cost of sales. Gross profit margin is most useful when considering companies that actually produce goods.
One particularly popular variation of profit margin is operating profit margin, which divides operating profit (revenue minus selling, general and administrative expenses) by revenue.
Investors and analysts may often use pretax profit margin, which divides pretax earnings (revenue without deducting tax costs) by revenue.