Profit Margin

Loading the player...

What is a 'Profit Margin'

Profit margin is part of a category of 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 one year Company A’s revenue is $1 million and its total expenditures are $750,000, making its profit margin 25% ($1M - $0.75M / $1M = $0.25M / $1M = 0.25 = 25%). If during the following year its revenue increases to $1.25 million and its expenditures increase to $1 million, its profit margin is then 20% ($1.25M - $1M / $1.25M = $0.25M / $1.25M = 0.20 = 20%). Even though its revenue has increased, Company A’s profit margin has diminished because 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, thereby reducing total revenue as well. 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'

Profit margin is a useful ratio and can help provide insight about a variety of aspects of a company’s financial performance.

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) or because of 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 because of 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, that it is operating in spaces that are too large and thus is paying too much in rent, and for many other reasons. On the other hand, a higher profit margin indicates a more profitable company that has better control over its costs compared to 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'

Though 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 that any investor should consider when considering a company’s profit margin.

While profit margin can be very useful for comparing companies with one another, one should only use profit margin to compare companies within the same industry, and ideally with similar business models and revenue numbers as well. Companies in different industries may often have wildly different business models, such that they may also have very different profit margins, thereby rendering a comparison of their profit margins relatively 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, so gross profit margin is less useful for determining management quality. Additionally, industries with no production process have no or little cost of sales, so 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.

To learn more about profit margins, check out A Look At Corporate Profit Margins and Profitability Indicator Ratios: Profit Margin Analysis.

RELATED TERMS
  1. Marginal Profit

    Marginal profit is the profit earned by a firm or individual ...
  2. After-Tax Profit Margin

    A financial performance ratio, calculated by dividing net income ...
  3. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company ...
  4. Operating Margin

    A ratio used to measure a company's pricing strategy and operating ...
  5. Profit

    A financial benefit that is realized when the amount of revenue ...
  6. Pretax Profit Margin

    A company's earnings before tax as a percentage of total sales ...
Related Articles
  1. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  2. Investing

    A Look At Corporate Profit Margins

    Take a deeper look at a company's profitability with the help of profit margin ratios.
  3. Investing

    What’s a Good Profit Margin for a New Business?

    Surprisingly, the younger your company is, the better its numbers may look.
  4. Investing

    What's a Good Profit Margin for a Mature Business?

    How to determine if the amount you clear dovetails with the competition.
  5. Investing

    What is Net Margin?

    The ratio of net profits to revenues for a company that shows how much of each dollar earned by the company is translated into profits.
  6. Investing

    Gross, Operating and Net Profit Margins

    A company’s income statement includes the company’s gross, operating and net profits.
  7. Investing

    Contribution Margin

    Contribution margin is a cost accounting concept that allows a company to determine the profitability of individual products.
  8. Investing

    4 Tips to Evaluate Growth Companies (KO, AAPL)

    Discover the best metrics for stock investors to utilize when selecting and evaluating the best opportunities in growth investing.
  9. Markets

    Do Declining Corporate Margins Point To Recession in 2016?

    Learn how declining profit margins have foretold nearly every recession of the past 50 years, and analyze whether they may signal economic contraction in 2016.
  10. Investing

    How Gross Margin Can Make or Break Your Startup

    Find out how your startup's gross margin can impact your business, including why a mediocre margin may spell disaster for a budding business.
RELATED FAQS
  1. What is the difference between gross profit margin and net profit margin?

    Understand the difference between the two profitability measures, gross profit margin and net profit margin, and how to calculate ... Read Answer >>
  2. Should I look at a company's operating profit or net profit?

    Explore the ways in which investors and market analysts use a company's operating profit and net profit margins for equity ... Read Answer >>
  3. What is the difference between gross margin and profit margin?

    Understand the difference between gross margin and profit margin, and learn about the profitability ratios used in evaluating ... Read Answer >>
  4. What's the difference between profit margin and operating margin?

    Find out the differences between a company's gross profit margin, net profit margin and operating margin, and what each metric ... Read Answer >>
  5. What is the difference between operating margin and profit margin?

    Understand the difference between operating margin and profit margin in relation to evaluating a company's profitability ... Read Answer >>
  6. What is the difference between operating margin and contribution margin?

    Understand the difference between two measures of profitability, operating margin and contribution margin, and the purpose ... Read Answer >>
Hot Definitions
  1. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  2. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  3. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  4. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  5. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  6. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
Trading Center