What it means
Raw profit figures are hard to compare. A company earning $100,000 on sales of $200,000 is much healthier than one earning $100,000 on sales of $10,000,000.
Profit margin fixes this by expressing profit as a percentage of revenue. There are three margins that are commonly quoted.
Gross margin deducts only the direct cost of sales, operating margin also deducts overheads such as salaries and rent, and net margin deducts everything including interest and tax. Each answers a different question, from how well the product earns to how much is left for the owners.
Typical margins vary hugely by industry. Supermarkets operate on thin margins and rely on high volume, while software companies often show high gross margins because extra copies cost little to supply.
Comparing a business with its own history and with similar firms is more useful than judging it against a general rule. Managers improve margin through four main levers: raising prices, cutting direct costs, controlling overheads and shifting the mix of sales towards more profitable products.
A small change can have a large effect. On a 5% margin, a 1% price increase that does not lose any customers could lift profit by a fifth.
There is also a nuance about growth. A business can raise its profit in dollars while its margin falls, if costs grow faster than sales, and this is often the first sign of trouble.
The reverse can also hold, where a smaller business has a better margin but less total profit. Margin should not be confused with markup.
Markup is profit as a percentage of cost, and margin is profit as a percentage of the selling price, so a 25% markup is only a 20% margin. Mixing the two up leads to underpricing.
In practice
Real-world examples
Example 1
A bakery sells a cake for $40 with ingredients and labour costing $28. The gross profit is $12, so the gross margin is 12 / 40 = 30%. The owner decides a $2 price rise would lift the margin to 33%, because the new gross profit is $14 on a $42 price. She tests it on one product for a month before changing the whole menu.
Example 2
An online retailer grows sales 30% but sees its net margin fall from 8% to 5% because of heavier advertising and delivery costs. The finance director shows that profit actually fell about 19%, since 1.3 x 5 / 8 = 0.81 of last year, and asks the marketing team to reduce spending on low-return campaigns.
Example 3
A consulting firm compares two services. Training has a margin of 45% and implementation work 20%. Partners decide to promote training more actively because it earns more per dollar of revenue. They keep implementation work for clients who buy both.
Think of it
Profit margin is like the percentage of your paycheck you actually save. Higher margins mean more of every dollar earned ends up as profit.
Formula
Calculation
Profit margin = profit / revenue x 100
Suppose a company has revenue of $1,000,000 and cost of goods sold of $600,000, so gross profit is $400,000 and the gross margin is 400,000 / 1,000,000 = 40%. Operating expenses of $250,000 leave operating profit of $150,000, an operating margin of 15%. After interest and tax of $60,000, net profit is $90,000 and the net margin is 90,000 / 1,000,000 = 9%.Case study
Seen in the real world
Brookside Outfitters is an illustrative, fictional clothing retailer whose sales rose 25% in a year, from $1,600,000 to $2,000,000. The owner celebrated, but the accountant pointed out that net margin had dropped from 9% to 6%, so profit had gone from $144,000 on $1,600,000 of sales to $120,000 on $2,000,000.
The accountant traced the decline to heavy discounting and free delivery offers used to win new customers. The owner replaced blanket discounts with a minimum order for free delivery and focused promotions on higher-margin lines. Within two quarters, the illustrative margin recovered to 8% on slightly lower sales, and total profit rose.
The owner now sets a minimum margin for each promotion before it goes live. A discount that would take the margin on a line below 25% needs the accountant's approval. The illustrative result was fewer sales events, but a steadier and healthier profit.
Watch out
Common mistakes
- Confusing margin with markup, which leads to prices that are too low.
- Celebrating higher sales without checking whether the margin has held up.
- Comparing margins between industries with completely different cost structures.
Questions
People also ask
What is a good profit margin?
It depends on the industry, so the best comparison is with similar businesses and with your own past results.
What is the difference between gross, operating and net margin?
Each deducts a different set of costs, with gross margin deducting only direct costs and net margin deducting all costs. On $1,000,000 of sales, a 40% gross margin and a 9% net margin mean $400,000 and $90,000 of profit respectively.
Can a profitable business have a falling margin?
Yes, if costs rise faster than sales the margin falls even while total profit grows.
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