What is Profit Margin?
Profit margin refers to the percentage of total revenue that remains after all costs, taxes and other expenses have been deducted. You can think of profit margin as a way to assess how much profit your company is making on every dollar of sales.
How is Profit Margin calculated?
Profit margin can be calculated using a simple formula:
Profit Margin = (Total Sales – Total Expenses) / Total Sales
Here is a simple example of how it works:
Let us assume that your company made $500k in sales last year. After you have deducted all of your costs and expenses, such as rent, salaries, cost of goods, etc., you’re left with net profits of $100k. Now, all you need to do to calculate your profit margin is to divide net profits by total sales.
$100k / $500k = 0.2, or 2%, as profit margin is typically expressed in percentages.
Why does Profit Margin matter?
Profit margin, or marginal cost, is a popular and helpful ratio for gauging a company’s financial health and profitability. In general, profit margin can provide a decent insight about different aspects of a company’s financial performance:
- the profitability and stability of a business
- company’s ability to manage expenses
- company’s pricing strategy
- company’s performance vs. competition
- company’s investability potential
Low profit margins could suggest a wide array of issues, from inability to efficiently manage expenses and overheads, to inadequate pricing strategy. It’s crucial for businesses to monitor their profit margin closely, as it’s a great tool to identify areas ripe for improvement and optimize their earnings.
Interestingly enough, higher revenue doesn’t always translate into higher profit margin. If expenses associated with higher sales have increased faster than the revenue, the company can actually end up making less money. That’s why keeping the costs low, effectively managing the inventory and optimizing the pricing strategy for maximum profit is as much a determining factor for healthier profit margin as increased sales.
Essentially, there are only two ways for companies to achieve better profit margin:
- Generate more revenue while keeping the costs low
- Lower the costs while generating the same amount of revenue
Since generating additional revenues is often more difficult, businesses typically experiment with revenue optimization strategies and tend to look for opportunities to cut down on costs and fine-tune their pricing strategy to improve their profit ratio.
Although profit margin can be useful for comparing companies with one another, the comparisons should only be drawn between companies within the same industry and ideally, with similar business models. Seasonality and cyclical sales trends should also be taken into consideration when comparing profit margin over a specific time period.