Word of the Week 'Profit Margin'


Profit Margin

What is a 'Profit Margin'

Profit margin is a profitability ratio calculated as net income divided by revenue, or net profits divided by sales. Net income or net profit may be determined by subtracting all of a company’s expenses, including operating costs, material costs (including raw materials) and tax costs, from its total revenue. Profit margins are expressed as a percentage and, in effect, measure how much out of every dollar of sales a company actually keeps in earnings. A 20% profit margin, then, means the company has a net income of $0.20 for each dollar of total revenue earned.

While there are a few different kinds of profit margins – including “gross profit margin,” “operating margin,” (or "operating profit margin") “pretax profit margin,” and “net margin” (or "net profit margin") – the term “profit margin” is also often used simply to refer to net margin. The method of calculating profit margin when the term is used in this way can be represented with the following formula:

Profit Margin = Net Income / Net Sales (revenue)

Other types of profit margins have different ways of calculating net income so as to break down a company’s earnings in different ways and for different purposes.

Profit margin is similar but distinct from the term “profit percentage,” which divides net profit on sales by the cost of goods sold to help determine the amount of profit a company makes on selling its goods, rather than the amount of profit a company is making relative to its total expenditures.

BREAKING DOWN 'Profit Margin'

Rarely can a company’s individual numbers (like revenue or expenditures) indicate much about the company’s profitability, and looking at the earnings of a company often doesn't tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For example, suppose Company A’s revenue for one year is $1 million, and its total expenditures are $750,000. This would yield a profit margin of 25% ($1M - $0.75M / $1M = $0.25M / $1M = 0.25 = 25%). If, during the following year, its revenue increases to $1.25 million, and expenditures increase to $1 million, its profit margin is then 20% ($1.25M - $1M / $1.25M = $0.25M / $1.25M = 0.20 = 20%). Although revenue has increased, Company A’s profit margin has diminished as expenses have increased at a faster rate than revenue.