Profit Margin

Quantitative measures used to compute the earnings and losses generated by a business

Businesses and individuals all over the world engage in for-profit economic activities to generate profits. However, absolute numbers, such as $X million in gross sales, $Y thousand in business expenses, or $Z in earnings, fail to provide a clear and realistic picture of a company's profitability and performance.

Several quantitative measures are used to compute the earnings and losses generated by a business, making it easier to assess a business's performance over time or compare it to competitors. These are known as profit margins.

They are classified into several types. In everyday parlance, however, it usually refers to a company's bottom line after all other expenses, including taxes and one-time oddities, have been deducted from revenue.

While proprietary businesses such as local shops can compute profit margins at their desired frequency, large enterprises, including publicly traded companies, report profit margin results per standard reporting timeframes on a quarterly or annual basis.

Businesses that rely on borrowed funds may be required to compute and report it to their lender (such as a bank) every month as part of standard operating procedures. They are divided into four categories: gross profit, operating profit, pre-tax profit, and net profit.

Types of Profit Margins

The following are 4 types: 

1. Gross Profit Margin

It is calculated by taking sales and subtracting costs directly related to creating or providing the product or service, such as raw materials and labor. These are typically bundled as "cost of goods sold," "cost of products sold," or "cost of sales" on the income statement.

A gross margin is most useful for a company to examine its product suite when done per product (though this data isn't shared with the public). Still, aggregate gross margin does show a company's rawest profitability picture.

2. Operating Profit Margin

It is calculated by subtracting selling, general and administrative, or operating expenses from a company's gross profit. It is also known as earnings before interest and taxes, or EBIT.

Profit generated by a company's main, ongoing operations generates income that can be used to pay debt and equity holders, as well as its taxes. In addition, bankers and analysts frequently use it to determine the value of an entire company for potential buyouts. As an illustration:

Operating Profit Margin = Operating Income / Revenue* 100 

3. Pre-tax profit margin

Take operating income and subtract interest expense while adding interest income, adjusted for non-recurring items such as earnings or losses from discontinued operations, and you have pre-tax profit or earnings before taxes (EBT); divide by revenue to get the pre-tax profit margin.

All major profit margins compare residual (leftover) profit to sales. For example, a 42% gross margin means that for every $100 in revenue, the company pays $58 indirect costs associated with producing the product or service, leaving $42 as gross profit.

4. Net profit margin

Consider it the most important of all the metrics, and what most people mean when they ask, "What is the company's profit margin?"

It is calculated by dividing net profits by net sales or net income by revenue over a specific period. Net profit and net income are used interchangeably in profit margin calculations. Similarly, the terms sales and revenue are interchangeable.

Net profit is calculated by deducting all associated expenses from the total revenue generated, including costs for raw materials, labor, operations, rentals, interest payments, and taxes.

Profitability = Net Profits ( or Income ) / Net Sales ( or Revenue )

=( Net Sales - Expenses )/ Net Sales = 1-( Expenses / Net Sales )

NPM = ( RR − COGS − OE − O − I − T ) × 100 or NPM = ( R Net income )×100

NPM=net Profitability

R=revenue

COGS=cost of goods sold

OE=operating expenses

O=other expenses

I=interest

T=taxes

Dividends are not considered an expense and are not factored into the formula.

Using a simple example, if a company made $100,000 in net sales in the previous quarter and spent $80,000 on various expenses, then:

Profitability = 1(($80,000/$100,000))

= 1-0.8

=0.2 percent (20%)

This means that the company earned 20 cents for every dollar of sales during the quarter. Consider this example to be the baseline for subsequent comparisons.

Profitability Formula Analysis

A closer look at the formula reveals that profitability is calculated using two numbers: sales and expenses. 

To maximize the profitability, which is calculated as 1 - (Expenses/Net Sales), look to minimize the result of the division of (Expenses/Net Sales). This is possible when expenses are low and net sales are high.

Let's dig deeper by expanding on the preceding base case example.

If the same company generates the same amount of sales worth $100,000 while spending only $50,000, its profitability is  

=1-($50,000/$100,000) = 50%

If the costs of generating the same sales are reduced further to $25,000, the profitability increases to 

=1 - ( $25,000/$100,000) = 75%

In conclusion, cutting costs helps to improve profitability.

If, on the other hand, expenses remain constant at $80,000 and sales increase to $160,000, the profitability increases to

=1-($80,000/$160,000) = 50%

Increasing the revenue to $200,000 while maintaining the same expenses results in the profitability of

=1-($80,000/$200.000) = 60%

In conclusion, increasing sales increases profitability.

Based on the scenarios presented above, it is reasonable to conclude that increasing sales and decreasing costs can improve profitability. In theory, higher sales can be achieved by raising prices, increasing the number of units sold, or both.

In practice, a price increase is only possible to the extent that the business does not lose its competitive edge in the market. While sales volumes remain dependent on market dynamics such as overall demand, the percentage of market share commanded by the business, and competitors' current and future position moves.

Likewise, the scope for cost controls is limited. A non-profitable product line can be reduced or eliminated to reduce expenses, but the business will also lose the corresponding sales.

In all scenarios, adjusting pricing, volume, and cost controls become a delicate balancing act for business operators.

Profitability, in essence, serves as an indicator of the ability of business owners or management to implement pricing strategies that result in higher sales while efficiently controlling various costs to keep them to a minimum.

Machine Learning Package Course

Everything You Need To Master Algo Trading using Python

To Help You Thrive in One of the Most Future Proof Careers on Wall Street.

Learn More

Making Use of Profitability

Profitability figures are widely used and quoted by all types of businesses around the world, from a billion-dollar publicly-traded company to an average Joe's sidewalk hot dog stand.

It also indicates the profitability potential of larger sectors and overall national or regional markets, in addition to individual businesses. 

Headlines like "ABC Research warns on declining Profitability in the American auto sector" or "European corporate Profit are breaking out" are common.

In essence, earnings have become the globally accepted standard measure of a company's ability to generate profits and are a top-level indicator of its potential.

It is one of the first few key figures to appear in company quarterly results reports. Internally, business owners, management, and external consultants use it to address operational issues and study seasonal patterns and corporate performance over various timeframes.

A business with zero or negative earnings is either struggling to manage its expenses or failing to achieve good sales.

A deeper dive identifies leaking areas, such as high unsold inventory, excess underutilized employees and resources, or high rentals, and then develops appropriate action plans. 

Earnings can be used by businesses with multiple business divisions, product lines, stores, or geographically dispersed facilities to assess and compare the performance of each unit. In addition, when a company seeks funding, earnings are frequently considered.

Individual businesses, such as a local retail store, may be required to provide it to obtain (or restructure) a loan from banks and other lenders. Therefore, it is also important when taking out a loan with a business as collateral. 

Large corporations that issue debt to raise capital are required to reveal their intended use of collected capital, which provides investors with information about earnings that can be achieved through cost-cutting, increased sales, or a combination of the two. 

The figure has become an essential component of equity valuations in the primary market for initial public offerings (IPOs). 

Finally, earnings are an important factor for investors to consider. For example, investors considering funding a specific startup may want to consider the earnings of the potential product/service being developed. 

Investors frequently focus on earnings when comparing two or more ventures or stocks to determine which is superior.

Earnings Comparison

However, the earnings cannot be used as the sole criterion for comparison because each business operates in its unique way. 

Typically, all businesses with low profits, such as retail and transportation, will have high turnover and revenue, resulting in overall high profits despite the low-earnings figure.

Although high-end luxury goods have low sales, high profits per unit compensate for low profits. The earnings of four long-running and successful companies in the technology and retail sectors are compared below:

Microsoft and Alphabet have high double-digit quarterly earnings, whereas Walmart and Target have single-digit margins. However, this does not imply that Walmart and Target did not generate profits or were less successful businesses than Microsoft and Alphabet.

A comparison of stock returns between 2006 and 2012 shows that the four stocks performed similarly, though Microsoft and Alphabet's earnings were significantly higher than Walmart and Target during that period. 

Because they are from different industries, comparing them solely on earnings may be inappropriate. 
Comparisons of earnings between Microsoft and Alphabet, as well as Walmart and Target, are more appropriate.

Industries with High-profit Examples

Luxury goods and high-end accessories businesses frequently have high-profit potential but low sales. 

Few expensive items, such as a high-end car, are ordered to build-that is, the unit is manufactured after the customer places the order, making it a low-cost process with few operational overheads.

Software or gaming companies may initially invest in developing a specific software/game and then profit handsomely later by selling millions of copies at a low cost. 

Entering strategic agreements with device manufacturers, such as offering pre-installed Windows and Microsoft Office on Dell-manufactured laptops.

Pharmaceutical companies, for example, may incur high research costs at first, but they profit handsomely by selling patent-protected drugs with no competition.

Examples of Low-Profit Industries

Transportation businesses, which must deal with fluctuating fuel prices, driver perks and retention, and vehicle maintenance, typically have lower earnings.

Due to weather uncertainty, high inventory, operational overheads, the need for farming and storage space, and resource-intensive activities, agriculture-based ventures typically have low earnings.

Automobiles also have low earnings due to intense competition, uncertain consumer demand, and high operational expenses associated with developing dealership networks and logistics.

Accounting Foundations Course

Everything You Need To Build Your Accounting Skills

To Help You Thrive in the Most Flexible Job in the World.

Learn More

Researched and authored by Javed Saifi | Linkedin

Edited by Colt DiGiovanni | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: