The 3 Types of Profit Margin and What They Tell You
The profit margin is a ratio of a company's profit divided by its revenue. It's always expressed as a percentage. It tells you how well a company uses its income. A high ratio means the company generates a lot of profit for every dollar of revenue. A low percentage means the firm's high costs reduce the profit for each dollar of income.
You can use the profit margin to compare the success of large companies versus small ones. You might think a large company is doing well because it has billions in revenue and billions in profit. But if its profit margin is low, it might not be doing as well as a much smaller company that has a better ratio.
The profit margin also allows you to compare your company against your competitors. You can see how you rank compared to your industry standard. You can also use it to see how you improve over time.
How to Calculate Profit Margin
The profit margin formula simply takes the formula for profit and divides it by the revenue. The profit margin formula is π / R, where:
- π = R - C (The symbol pi stands for profit.)
- R (revenue) = Price * X (number of units)
- C (costs) = F + V * X
- F = fixed cost, such as the cost for a building. It does not include financial costs, such as interest on debt taken out to purchase a building, etc.
- V = Variable cost, such as the cost to produce each product. It does not include financial costs needed to produce each unit.
- X = number of units
Types of Profit Margin
There are three types of profit margins with their own calculations. They differ by what they include in costs. Each type tells managers different things about the business.
Gross profit margin compares revenue to variable costs. It tells you how much profit each product creates without fixed costs. These variable costs are the same as the cost of goods sold. Firms use it to compare product lines, such as auto models. It's not used in service companies, such as law firms, that have no COGS.
The gross profit margin formula is π / R, where:
- π = R – C
- R = Price * X
- C = V * X
Operating profit margin includes both variable and fixed costs. It is the same as the margin ratio. It doesn't include certain financial costs. It does include all operating costs and overhead. These include personnel costs and administration, along with variable costs, or COGS. It is misleading when a company's financial costs, like taxes, are high.
The operating profit margin formula is π / R, where:
- π = R - C
- R = Price * X
- C = F + V * X
Net profit margin is net profit divided by net revenue. The is revenue minus all expenses. These include both operating and financial expenses. Revenue is subtracted, including taxes, interest expenses, and depreciation. That's profit after subtracting the costs of interest, tax, and depreciation.
Net revenue remains after the subtraction of all returns and allowances. It's used like the profit margin ratio, except for one important difference. It's not good for comparing companies in different industries. That's because they have very different costs.
The net profit margin formula is π / R, where:
- π = R - C
- R = Price * X
- C = F+ V * X
How the Profit Margin Affects the Economy
The profit margin is critical to a free market economy driven by capitalism. The margin must be high enough to reward the owners of the company for their risk. Otherwise, they will close the company and invest in something else. That's how profit margins determine the supply for a market economy. If a product doesn't create a profit, companies won't supply it no matter how high the demand.
Profit margins are a large reason why companies outsource jobs. They cannot hire expensive U.S. workers, sell their products at a competitive cost, and maintain reasonable margins. To keep prices low, they must move jobs to lower-cost workers in Mexico, China, and other foreign countries. People complain that companies are greedy, but that's the role of profit margins. No one will stay in business in a market economy without them.
The margin may also set the price. That's because some companies determine that they must receive a certain margin. They just make the price that much higher than the cost. For example, retail stores must have a 50 percent gross margin to cover costs of distribution plus return on investment. That margin is called keystone. They double the price over wholesale. Companies that are regulated, like utilities, also use this method. The regulatory agency sets their profit margin. They also price the good or service at cost plus margin.