Finance & Accounting

A Brief Overview on Profit Margin

Profit Margin is one of the most commonly used financial ratios in corporate finance. It is a financial ratio to determine the financial status of a company. In this article, we shall have a brief overview of it.

Meaning of Profit Margin

It is one of the profitability measures which is widely used to know the degree to which a corporation or an enterprise is making money. It shows what % of revenue is profits. The % figure showcases how many cents of profits a company has generated for every dollar of sale.

There are a variety of margin for benefit, but in daily use, it typically pertains to the net profit margin, bottom line of business after all other costs were taken out of sales.

What do Profit margins show?

It shows the following:

• Potential of the company to convert income into profit;
• How well the company deals with the financial obligations;
• The financial status of the company against the escalating competition.

Gross profit, net profit and operating profit margins

Gross Profit Margin-

It is a profitability metric that shows profit as a net income that exists after deducting cost of goods sold. In this case, cost of goods sold is associated with expenses linked with manufacturing or production of items for sale. It also includes the cost of raw material and wages of the labor who is accountable to make goods. Some are not a part of this metric like taxes, debt, overhead, cost or expenditure with respect to equipment purchases.

This form of margin of profit deals with gross profit and total revenue. It implies the net profit retained after deducting the production cost. The formula for this is GPM^[1]= Net Sales- cost of goods sold/Net Sales.

Operating Profit Margin

This is slightly tricky than its counterparts. It takes into account different variables to estimate the profitability of the firm. These variables are sales expenses, overhead costs, operating expenses, and administrative costs. These variables are directly associated with company’s operation. While this profitability metric still doesn’t take into account debts, taxes and other non-operational expenses, it does include depreciation of assets and amortization.

The operating margin of profit is estimated by dividing the operating profit by revenue. The profitability metric shows the financial status of the company to run its business.

Net Profit Margin

The net income of the company is equal to the total revenue left after all expenses. This includes the manufacturing cost and cost of goods sold, but it also takes into account debt, taxes, single outstanding payment and also income from other operations. It shows the ability of the firm to turn the input costs into profit.

How to improve your profit margin?

Here are some tips to achieve the goal:

• Reduce the overall operating costs

Consider reducing your overall operating costs. It includes office space and utilities, materials, insurance, equipment, shipping and business software. Try negotiating a lower rate or eliminate any unnecessary services.

• Cut underperforming products or services or add higher margin products

Figure out whether a product is indeed profitable. You can learn from other companies in your sector or research on high margin products. You would be required to weigh the cost of goods sold and operating expenses against your selling price. 

• Adjust pricing strategy

Experiment with various product pricing methods such as value based pricing or cost plus pricing.

• Build brand loyalty

Engage with your customers regularly and show customer appreciation as it has a tangible effect. Retaining more customers allows you to lower your advertising costs.

Impact of Profit Margin on the Economy

In a capitalism driven economy, the margin of profits is essential. The margin should be on par with counterparts dealing with similar business to lure investors. It helps to estimate the supply. In case a service or a product doesn’t work out well, then the company would not wish to further supply it in the market.

In order to achieve good margins, the firm may outsource jobs overseas where labour charges are lower. This will help them to reduce production expenditure. Further, to keep the production cost low, companies often look to try different tactics to keep financial obligations under control. These margins help the firm to price its product and services to beat the competition.

Conclusion

It can be concluded that profitability metrics are essential determinants of the growth of a company. They are vital and capable of highlighting weaknesses in the financial setup of the company. These metrics have helped business owners to make changes when necessary to get good profit and reduce financial losses. Moreover, these metrics are critical as it allows the investors and the owner to know where the company stands in the competition. 

Read our article: Profit Maximization Strategies- How to turn your business more profitable?