The profit margin ratio is used to compare profit to sales to give an organization a picture of how well they are faring financially. This ratio is always expressed as a percentage and is divided into three categories.
What is Profit Margin?
Profit margin is a profitability ratio that gauges the degree to which a company or a business makes a profit (i.e.) money. It portrays what percentage of sales has been converted into profits.
Importance of Profit Margin
A profit margin is a map that shows you how much money your business is making, the general welfare of your business as well as the problems you need to fix in your business.
It is also used by creditors, investors, and businesses to gauge a company’s financial health, management skills, as well as growth potential.
Types of Profit Margin
There are three levels of profit margin namely, gross profit margin, operating profit margin, and net profit margin. In everyday use, however, these profit margins refer to the net margin, (i.e.) a company’s bottom line after all expenses, including taxes and one-oddities, have been deducted out of the revenue.
Gross Profit Margin
The gross profit margin compares revenue to variable costs and tells you how much profit each product generates excluding fixed costs. Variable costs are costs that are incurred during a process that can change with production rates (output).
How to determine gross profit
Revenue –Direct materials + Direct labor + Factory overhead.
Revenue – Cost of Sales Returns, Allowances, and Discounts.
Gross profit margin formula
Gross Profits – Net Sales ×100
Operating Profit Margin
The operating profit margin includes both costs of goods sold, costs linked with selling and administration, and overhead. Even though the COGS formula is the same across most industries, the differentiating factor is what is included in each of the elements, which can vary for each.
Beginning inventory + Purchases – Ending Inventory.
Then add together all of your selling and administrative expenses, and use the same with the COGS and revenues in the formula:
Revenues + COGS – Selling and Administrative Expenses ÷ Revenues × 100.
Net Profit Margin
The net profit margin ratio is calculated as the percentage of a business’s revenue that is left after deducting all expenses from total sales, divided by net revenue. The net profit is total revenue minus all expenses.
Total Revenue – COGS + Depreciation and Amortization +Interest Expenses + Taxes + Other Expenses.
Use the net profit in the equation:
Net Profit ÷ Total Revenue × 100
This will give you the net profit.
What is a Good Profit Margin?
Even though there is no particular percentage when it comes to rating a good profit margin, because it varies considerably by industry, as a general rule of thumb, the following applies: a 10% net profit margin is considered average, a 20% margin is considered high or “good”, and a 5% margin is seen as low.
In conclusion, note that this ratio is not a good comparison tool across different industries, due to the different financial structures and costs different industries use. Thus, care should be taken when comparing the figures for different businesses.
To avoid running your business in the dark, which can cause you to be stagnated, use the profit margin ratio suitable for your business to now the health of your business. This will help you make adjustments where necessary and ultimately give you the profit you desire.