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Profit Margin


 

Profit margin is a commonly used ratio that measures what percentage of a business’s earnings have been turned into profit over a specified period of time. It’s used to assess the financial success and growth of a business as a whole or specific products or services they sell.


For example, if a company’s profit margin is 25%, this means that it had a net income of 25 cents for each dollar of sales generated. In other words, the more money a company makes per sale, the higher its profit margin.


What is the formula for profit margin?


Profit Margin = (Total Sales - Total Expenses) / Total Sales


By analyzing the profit margin, we can take a better look at what the numbers—sales and expenses—really indicate. If a business wants to maximize its profit margin, that means it has to generate a high amount of sales relative to its spending.

For example, a business could make $1,000 by spending $500. So $1,000-$500/$1,000 = 50% profit margin. Keep expenses low and net sales high.


 

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Understanding profit margin in 4 parts


There are four levels of profit margin: gross profit, operating profit, pre-tax profit and net profit. Let’s take a look at each of these profit margins.


Gross profit margin: This is used specifically for measuring the financial success of a business’s products and services, rather than that of the business development as a whole. It’s often used by a business to determine pricing costs. It’s a ratio usually expressed as a percentage which comes from gross profit, a company’s total sales after deducting the costs associated with selling its products and/or services. The higher the gross profit margin is, the better the company is performing.


The formula is as follows:

Gross profit margin (%) = (*Gross profit / total sales) x 100


*To calculate gross profit, you can use this formula: Gross profit = Total sales – cost of goods sold


Operating profit margin: Businesses can calculate their operating profit by subtracting operating expenses from their gross profit amount. This is also known as earnings before interest and taxes. Operating profit is used by bankers and analysts to determine a company’s value for potential buyouts.


The formula is as follows:

Operating profit margin (%) = (Operating expenses/total revenue) x 100


Pre-tax profit margin: This is the operating expenses subtracted from interest and taxes. It is a ratio showing how many cents of profit has been generated for each dollar of sale. Thus, pre-tax profit margin is used to compare the profitability of businesses in the same sector.


Net profit margin: This is a measurement of a business’s financial success in terms of profit compared to their overall revenue. It’s a percentage indicator of a business’s profitability as a whole, not just its products or services. Net profit margin is used to compare a business’s success over time, determine hindering costs, and compare their strength to others in their industry. The higher the net profit margin, the more profitable the business is.


The formula is as follows:

Net profit margin (%) = (*Net profit / total sales) x 100


*To calculate net profit, you can use this formula: Net Profit = Revenue - Cost of goods sold - Operating expenses - Interest payments - Taxes


Related Term

Gross Profit

Related Term

Fiscal Year

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