The goal of any business is to improve its net margin. Also called the net profit margin, this profitability metric is the most comprehensive evaluative ratio used in corporate finance. By dividing net profit by total sales, the net margin reflects a company's ability to turn revenue into profit after accounting for all the expenses of running the business, including taxes and debt payments.

When a company's net margin exceeds the average for its industry, it is said to have a competitive advantage, meaning it is more successful than other companies that have similar operations. While the average net margin for different industries varies widely, how businesses can gain a competitive advantage remains constant, whether they increase sales or reduce expenses.

Key Takeaways

  • Net margin measures the profitability of a firm by dividing its net profit by total sales.
  • A firm has a competitive advantage when it's net margin exceeds that of its industry.
  • Companies can increase their net margin by increasing revenues, such as through selling more goods or services or by increasing prices.
  • Companies can increase their net margin by reducing costs (e.g., finding cheaper sources for raw materials).

Boosting Revenues to Improve Net Margin

Improving the net margin through increasing revenue is generally the most popular option. Businesses can increase sales income by raising the price of products or by selling more of them.

However, businesses must be wary of alienating customers with inflated prices. If demand for the product isn't high enough, an ill-timed production surge can leave valuable inventory depreciating in a warehouse, damaging the bottom line. A prudent pricing strategy must take into account what the market will bear in terms of supply, and as well as price.

While increasing sales revenues is beneficial to the bottom line, it serves as a double-edged sword when it comes to the net margin. Increased revenues lead to increased profits, but they also mean a larger figure at the bottom of the net margin equation. Because the net margin formula divides net profit by sales, the benefit of additional revenues is somewhat offset when using this metric. The best strategy is to focus on increasing sales and decreasing expenses simultaneously.

Reducing Costs to Improve Net Margin

Some of the greatest expenses a company incurs come from the day-to-day running of the business and the production of goods for sale. Operating expenses can be reduced by relocating headquarters to a cheaper part of town, leasing smaller factory space, or reducing the workforce.

However, all of these options can have an important impact on the intangible assets of a company, such as public perception and goodwill. Another way to control costs is to find cheaper sources for the raw materials needed to manufacture goods. On the other hand, if a company starts producing inferior-quality products to cut expenses, it is likely to lose many of its customers to competitors.

To reduce the cost of production without sacrificing quality, the best option for many businesses is expansion. Economies of scale refer to the idea that larger companies tend to be more profitable. A large business's increased level of production means that the cost of each item is reduced in several ways. Raw materials purchased in bulk are often discounted by wholesalers.

Also, higher production levels mean that the costs of advertising, research, development, depreciation, and administration are more spread out. Funding expansion can be an effective long-term strategy for improving the net margin because it increases production capacity, drives higher sales volume, and reduces the average cost per item produced.