Profit margin is defined as a ratio of profits earned to total costs over a defined period (monthly, quarterly, annually, etc.). Each industry generally has its own average profit margin due to the differences in costs and materials needed for different products and services.
There are two types of profit margin that owners might find useful:
Gross Profit Margin: The gross profit margin equation is typically used to determine the profit margin of a singular product or service, not of an organization as a whole. To determine the gross profit margin, a business looks at the retail price of its product and subtracts the cost of materials and labor used to produce it. It then divides that by the retail price. For example, if you sell a product for $100, and it costs $50 to make, the gross profit margin is 50% ($50 divided by $100).
Net Profit Margin: This is often the equation used to determine an entire organization’s profit margin. Net profit margin is calculated by taking the company’s total sales for a given time period, subtracting total expenses and then dividing that figure by total revenue. For example, let’s say your company generates $1 million in sales and has operating expenses of $250,000. The net profit margin would be 75% ($1,000,000 – $250,000 = $750,000; $750,000 divided by $1,000,000 equals 75%).
So how is this measurement used?
Maybe you offer multiple products, you can use the GPM to determine which is most profitable. By calculating the profit margins, you will know which product or service is generating more profit for your company and which ones need improvement. If you find a product or service is hurting your margins, maybe it’s time to scrap that offering. Or you could focus on decreasing expenses or increasing sales price of that product.
What if margins are great? Maybe it’s time for you to start exploring growth for your business. Maybe increase sales?
Now the Net Profit Margins are a great check annually to find out if you are improving on your margins. Many owners just use the sales figure to measure their company, but using NPM takes into account the expenses. When you prepare your books for tax time this year, just pull the information from your financial statements and check your numbers. The numbers tell a story, so make sure you understand the story.