Profit margins, very simply, tell you how much percentage profit you’re making after different types of expenses are deducted. They are ratios which give you information about where each dollar that your company makes goes. A profit margin will tell you what percentage of each revenue dollar is profit. You can look at that in comparison to what percentages go toward producing products or paying you business operating expenses.
For example, Company X made $75,500 in one year. It breaks down like this:
Net Profit Margin is being calculated here, showing all of the company’s costs compared to all of the company’s revenue. Salary was 66% of the company’s total revenue, Cost of Goods Sold was 13%, while net profit itself was 4%.
Part 2 in the Series: Understanding Business Reporting
So what kind of margins do you want?
The big question is – what is normal for margins? What should you be going for?
In a lot of cases people compare themselves to how other people are doing in their market, a process called benchmarking. Some people like benchmarking, and some don’t. You can find benchmarks for your particular industry through financial reporting software, or you can check Net Profit Margins, Gross Margins, and Operating Margins on sites like Ready Ratios. It’s common for news outlets to report on which types of companies have high profit margins, with the idea that people might want to get into those industries just because of their high margins.
However, a high net profit isn’t the only game in town. It’s important to remember that profit margins aren’t everything. People get into business for all kinds of reasons, and have all types of goals for their funds in addition to and sometimes despite profit margins.
For all businesses, net profit goals are really what you make of them. Is it important to you to pay your staff well? Then your ratios might look different from someone whose goal is to put more money back into producing product, or someone whose goal is to maximize net profit. It’s important to take the time to identify your business priorities and goals, because they should play a big part in identifying if your profit margins are appropriate for your business.
It’s also the case that not all businesses have the same types of expenses, and this has a big impact on profit margins. Maybe your business requires more advertising than another business. Maybe your business is people-dependent. Perhaps your business type doesn’t require COGS, while another one does. Questions like these are important to consider when looking at different types of margins.
How do you calculate margins?
Business profit margins can be calculated three different ways. Here are the simple formulas.
Gross profit margin:
((Gross Revenue-Cost of Goods Sold) / Gross Revenue) x 100
This profit margin tells you profit after COGS has been deducted. This shows how profitable the company is after the costs of manufacturing or producing a product are.
Operating profit margin:
((Gross Revenue – COGS – Operating Expenses) / Gross Revenue) x 100
This profit margin tells you your percentage profitability after both COGS and operating expenses have been deducted. It takes into account fixed and variable costs of running a business including payroll, rent and overhead, as well as depreciation and amortization.
Net Profit margin:
((Gross Revenue – COGS – Operating Expenses – Taxes + Investment income – Debt payments and interest) / Gross Revenue) x 100
This final profit margin gives you profitabilty after ALL expenses and other types of revenue/income have been taken into account, such as taxes and investment income. These expenses are “below the bottom line” expenses like taxes and debt payments.
This example shows all of Company X’s expenses from their Profit and Loss statements. It also includes additional expense information from the balance sheet at the bottom to show below-the-bottom-line expenses for the Net Income calculation.
The three types of profit margins are calculated at the bottom of the table above. You can see that the company, despite increasing expenses, managed to increase revenue enough to compensate. Their net profit margins showed a generally upward trend. They also decreased the percentage of revenue necessary for producing product each year.
This compares Company X’s profit margins each year. The company had very little in below-the-bottom line expenses (not much tax or debt payments), so their operating profit margins look very similar to their net profit margins.
Profit Margin’s Importance
Profit margin is one factor in computing a business’s general financial health. It’s not the only thing that a business should look for, however. Cash flow is equally important, for example (see part 1 in this Understanding Business Reporting: Cash Flow Isn’t the Same As Profit).
As stated above, a business’s goals and priorities are also important when considering profitability. Just because your net profit is high doesn’t necessarily mean that the business accomplished its goals. Perhaps it had a net profit margin of 20%, but was falling behind in purchasing COGS, leaving not enough product for sale each year. Perhaps the employees haven’t had a pay raise in some time, and are considering leaving, taking valuable business insight with them. In these cases the business’s high profit margin indicates potential problems rather than an unqualified success.
On the other hand, perhaps a business had a profit margin of just 1%. However, upon closer inspection it’s revealed that they accomplished their goal of developing four new products for sale. Their research and development expenses were extra high for that year, as were their COGS. However, the expenditures left them positioned for greater potential profit in the following years. As a result, while their profit margin was low, it was appropriate and expected for their business activities that year.
Just like all reporting, profit margins should be one part of the equation when looking at a business’ health.