What is a Profit Margin?
Profit margin indicates the profitability of a product, service, or business. It’s represented as a percentage; the higher the number, the more profitable is the company.
Types of Profit Margins
Small businesses, including retailers, often look at two types:
- Net profit margin
- Gross profit margin
Gross Profit Margin
This margin usually refers to a specific product or line rather than an entire business. Measuring helps the company determine pricing decisions because a low gross profit could mean that the industry needs to charge more to make selling a specific product worthwhile.
Calculate it by subtracting the cost of goods sold from net sales. Divide the resulting number into the net sales to get the ratio, which represents the percentage. For example, if sales are $10,000 and costs total $7,000, the difference between the two is $3,000. Divide that difference by sales – $10000 – and multiply by 100 to get 25 percent. That is the gross profit margin.
Note that the cost of goods sold includes direct product costs but doesn’t include indirect costs, such as office supplies, rent, and so on.
Net Profit Margin
Unlike the gross profit, the net profit margin is a calculation that expresses the profitability of an entire business, not just a particular product or service. It is also expressed in a percentage; the higher the number, the more profitable the business. A low margin might indicate a problem that is conflicting with profitability potential, including unnecessarily high expenses, productivity issues, or management problems.
Let’s say gross sales are $100,000 and expenses are $80,000. That means net income is $20,000. Divide that number into gross sales, $80,000 divided by $100,000, to get .50. Multiplying .50 by 100 equals 50 percent, the net profit margin.
People using this margins to determine a company’s profitability are advised not to compare a company in one industry to a business in another. Industry characteristics vary so much that it’s unrealistic to expect a restaurant, for example, to be similar to an auto parts retailer.
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