What Is Profit Margin?

Profit margin is one of the commonly used profitability ratios to gauge the degree to which a company or a business activity makes money. It represents what percentage of sales has turned into profits. Simply put, the percentage figure indicates how many cents of profit the business has generated for each dollar of sale. For instance, if a business reports that it achieved a 35% profit margin during the last quarter, it means that it had a net income of $0.35 for each dollar of sales generated.

There are several types of profit margin. In everyday use, however, it usually refers to net profit margin, a company’s bottom line after all other expenses, including taxes and one-off oddities, have been taken out of revenue.

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Understanding Profit Margin

The Basics of Profit Margin

Businesses and individuals across the globe perform for-profit economic activities with an aim to generate profits. However, absolute numbers—like $X million worth of gross sales, $Y thousand business expenses or $Z earnings—fail to provide a clear and realistic picture of a business’ profitability and performance. Several different quantitative measures are used to compute the gains (or losses) a business generates, which make it easier to assess the performance of a business over different time periods, or compare it against competitors. These measures are called profit margin.

While proprietary businesses, like local shops, may compute profit margins at their own desired frequency (like weekly or fortnightly), large businesses including listed companies are required to report it in accordance with the standard reporting timeframes (like quarterly or annually). Businesses which may be running on loaned money may be required to compute and report it to the lender (like a bank) on a monthly basis as a part of standard procedures.

There are four levels of profit or profit margins: gross profit, operating profit, pre-tax profit, and net profit. These are reflected on a company's income statement in the following sequence: A company takes in sales revenue, then pays direct costs of the product of service. What’s left is gross margin. Then it pays indirect costs like company headquarters, advertising, and R&D. What’s left is operating margin. Then it pays interest on debt and adds or subtracts any unusual charges or inflows unrelated to the company’s main business with pre-tax margin left over. Then it pays taxes, leaving the net margin, also known as net income, which is the very bottom line.

Key Takeaways

  • Profit margin gauges the degree to which a company or a business activity makes money, essentially by dividing income by revenues.
  • Expressed as a percentage, profit margin indicates how many cents of profit the business has generated for each dollar of sale.
  • While there are several types of profit margin, the most significant and commonly used is to net profit margin, a company’s bottom line after all other expenses, including taxes and one-off oddities, have been removed from of revenue.
  • Profit margins are used by creditors, investors, and businesses themselves as indicators of a company's financial health, management's skill, and growth potential.
  • As typical profit margins vary by industry sector, care should be taken when comparing the figures for different businesses.

Types of Profit Margin

Let's look more closely at the different varieties of profit margins.

Gross Profit Margin

Gross profit margin: Start with sales and take out costs directly related to creating or providing the product or service like raw materials, labor, and so on—typically bundled as "cost of goods sold,” “cost of products sold,” or “cost of sales” on the income statement—and you get gross margin. Done on a per-product basis, gross margin is most useful for a company analyzing its product suite (though this data isn’t shared with the public), but aggregate gross margin does show a company’s rawest profitability picture. As a formula:

Gross Profit Margin formula
Gross Profit Margin formula. Investopedia

Operating Profit Margin

Operating Profit Margin (or just operating margin): By subtracting selling, general and administrative, or operating expenses, from a company's gross profit number, we get operating profit margin, also known as earnings before interest and taxes, or EBIT. Resulting in an income figure that’s available to pay the business' debt and equity holders, as well as the tax department, it's profit from a company’s main, ongoing operations. it’s frequently used by bankers and analysts to value an entire company for potential buyouts. As a formula:

Operatng profit margin formula
Investopedia

Pretax Profit Margin

Pretax profit margin: Take operating income and subtract interest expense while adding any interest income, adjust for non-recurring items like gains or losses from discontinued operations, and you’ve got pre-tax profit, or earnings before taxes (EBT); then divide by revenue, and you've got the pretax profit margin.

The major profit margins all compare some level of residual (leftover) profit to sales. For instance, a 42% gross margin means that for every $100 in revenue, the company pays $58 in costs directly connected to producing the product or service, leaving $42 as gross profit.

Net Profit Margin

Let's now consider net profit margin, the most significant of all the measures—and what people usually mean when they ask, "what's the company's profit margin?"

Net profit margin is calculated by dividing the net profits by net sales, or by dividing the net income by revenue realized over a given time period. In the context of profit margin calculations, net profit and net income are used interchangeably. Similarly, sales and revenue are used interchangeably. Net profit is determined by subtracting all the associated expenses, including costs towards raw material, labor, operations, rentals, interest payments, and taxes, from the total revenue generated.

Mathematically, Profit Margin   = Net Profits (or Income) / Net Sales (or Revenue)

                               = (Net Sales - Expenses) / Net Sales

                               = 1- (Expenses / Net Sales)

Or as a formula:

Net Profit Margin Formulas
Net Profit Margin Formulas.  Investopedia

Dividends paid out are not considered an expense, and are not considered in the formula.

Taking a simple example, if a business realized net sales worth $100,000 in the previous quarter and spent a total of $80,000 towards various expenses, then

Profit Margin    = 1 - ($80,000 / $100,000)

                               = 1- 0.8

                               = 0.2 or 20%

It indicates that over the quarter, the business managed to generate profits worth 20 cents for every dollar worth of sales. Let’s consider this example as the base case for future comparisons that follow.

Analyzing the Profit Margin Formula

A closer look at the formula indicates that the profit margin is derived from two numbers—sales and expenses. To maximize the profit margin which is calculated as {1 - (Expenses/ Net Sales)}, one would look to minimize the result achieved from the division of (Expenses/Net Sales). That can be achieved when Expenses are low, and Net Sales are high.

Let’s understand it by expanding the above base case example.

If the same business generates same amount of sales worth $100,000 by spending only $50,000, its profit margin would come to {1 - $50,000/$100,000)} = 50%. If the costs for generating the same sales further reduces to $25,000, the profit margin shoots up to {1 - $25,000/$100,000)} = 75%. In summary, reducing costs helps improve the profit margin.

On the other hand, if the expenses are kept fixed at $80,000 and sales improve to $160,000, profit margin rises to {1 - $80,000/$160,000)} = 50%. Raising the revenue further to $200,000 with the same expense amount leads to profit margin of {1 - $80,000/$200,000)} = 60%. In summary, increasing sales also bumps up the profit margins.

Based on the above scenarios, it can be generalized that the profit margin can be improved by increasing sales and reducing costs. Theoretically, higher sales can be achieved by either increasing the prices or increasing the volume of units sold or both. Practically, a price rise is possible only to the extent of not losing the competitive edge in the marketplace, while sale volumes remain dependent on market dynamics like overall demand, percentage of market share commanded by the business, and competitors’ existing position and future moves. Similarly, the scope for cost controls is also limited. One may reduce/eliminate a non-profitable product line to curtail expenses, but the business will also lose out on the corresponding sales.

In all scenarios, it becomes a fine balancing act for the business operators to adjust pricing, volume and cost controls. Essentially, profit margin acts as an indicator of a business owners’ or management’s adeptness in implementing pricing strategies that lead to higher sales, and in efficiently controlling the various costs to keep them minimal.

Using Profit Margin

From a billion-dollar publicly listed company to an average Joe’s sidewalk hot dog stand, the profit margin figure is widely used and quoted by all kinds of businesses across the globe. Beyond individual businesses, it is also used to indicate the profitability potential of larger sectors and of overall national or regional markets. It is common to see headlines like “ABC Research warns on declining profit margins of American auto sector,” or “European corporate profit margins are breaking out.”

In essence, the profit margin has become the globally adopted standard measure of the profit-generating capacity of a business and is a top-level indicator of its potential. It is one of the first few key figures to be quoted in the quarterly results reports that companies issue.

Internally, business owners, company management and external consultants use it for addressing operational issues and to study seasonal patterns and corporate performance during different timeframes. A zero or negative profit margin translates to a business either struggling to manage its expenses or failing to achieve good sales. A further drill-down helps identify the leaking areas—like high unsold inventory, excess yet underutilized employees and resources, or high rentals—and then devise appropriate action plans. Enterprises operating multiple business divisions, product lines, stores or geographically spread-out facilities may use profit margin for assessing the performance of each such unit and compare it against one another.

Profit margins often come into play when a company seeks funding. Individual businesses, like a local retail store, may need to provide it for seeking (or restructuring) loan from banks and other lenders. It also becomes important while taking out a loan against business as collateral. Large corporations issuing debt to raise money are required to reveal their intended use of collected capital, and that provides insights to investors about profit margin that can be achieved either by cost cutting or by increasing sales or a combination of both. The number has become an integral part of equity valuations in the primary market for initial public offerings (IPO).

Finally, profit margins are a significant consideration for investors. Investors looking at funding a particular startup may like to assess the profit margin of the potential product/service being developed. While comparing two or more ventures or stocks to identify the better one, investors often hone in on the respective profit margins.

Comparing Profit Margins

However, profit margin cannot be the sole decider for comparison as each business has its own distinct operations. Usually all businesses with low profit margins, like retail and transportation, will have high turnaround and revenue which makes up for overall high profits despite the relatively low profit margin figure. High-end luxury goods have low sales, but high profits per unit make up for high profit margins. Below is a comparison between profit margins of four long-running and most successful companies from technology and retail space:

Data Source: YCharts.com

Technology companies like Microsoft and Alphabet have high double-digit quarterly profit margins compared to the single-digit margins achieved by Walmart and Target. However, it does not mean Walmart and Target did not generate profits or were less successful businesses compared to Microsoft and Alphabet.

Graph Courtesy: Yahoo! Finance

A look at stock returns between 2006 and 2012 indicate similar performances across the four stocks, though Microsoft and Google's profit margin were way ahead of Walmart and Target's during that period. Since they belong to different sectors, a blind comparison solely on profit margins may be inappropriate. Profit margin comparisons between Microsoft and Alphabet, and between Walmart and Target is more appropriate.

Examples of High Profit Margin Industries

Businesses of luxury goods and high end accessories often operate on high profit potential and low sales. Few costly items, like a high-end car, are ordered to build – that is, the unit is manufactured after securing the order from the customer, making it a low-expense process without much operational overheads.

Software or gaming companies may invest initially while developing a particular software/game, and encash big later by simply selling millions of copies with very little expenses. Getting into strategic agreements with device manufacturers, like offering pre-installed Windows and MS Office on Dell-manufactured laptops, further reduces the costs while maintaining revenues.

Patent-secured businesses like pharmaceuticals may incur high research costs initially, but they reap big with high profit margins while selling the patent-protected drugs with no competition.

Examples of Low Profit Margin Industries

Operation-intensive businesses like transportation which may have to deal with fluctuating fuel prices, drivers’ perks and retention, and vehicle maintenance usually have lower profit margins.

Agriculture-based ventures usually have low profit margins owing to weather uncertainty, high inventory, operational overheads, need for farming and storage space, and resource-intensive activities.

Automobiles also have low profit margins, as profits and sales are limited by intense competition, uncertain consumer demand and high operational expenses involved in developing dealership networks and logistics.