Profit Margin – Definition

Cite this article as:"Profit Margin – Definition," in The Business Professor, updated June 2, 2019, last accessed May 29, 2020, https://thebusinessprofessor.com/lesson/profit-margin-definition/.

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Profit Margin Definition

In Mathematical terms:

Profit Margin     = Net Profits (or Income) / Net Sales (or Revenue)

= (Net Sales – Expenses) / Net Sales

= 1- (Expenses / Net Sales)

Dividends paid are not counted as expense, and thus not included in the formula.

Consider a simple example, if a business acquired net sales worth $100,000 in the last quarter and incurred $80,000 towards expenses, then

Profit Margin     = 1 – ($80,000 / $100,000)

= 1- 0.8

= 0.2 or 20%

It shows that in the quarter, the business generated the profits worth 20 cents per each dollar worth of sale. This example is the base case for our future comparisons in this article.

A Little More on What is Profit Margin

The de facto, Standard Profitability Indicator

Looking formula closely shows that profit margin is the resultant of two numbers – sales and expenses. For profit margin, calculated as {1 – (Expenses/ Net Sales)},  maximization, you should minimize the result produced by the division of (Expenses/Net Sales). That is achieved when Net Sales are high and Expenses low.

Using the above base case example, let’s understand it further:

If the business gained same amount of sales of $100,000 by incurring $50,000 expenses, its profit margin will be computed as {1 – $50,000/$100,000)} = 50%. If the costs for producing the same sales declines to $25,000 more, the profit margin  will increase {1 – $25,000/$100,000)} = 75%. In a nutshell, decreasing costs lead to improved profit margin.

On the contrary, if the expenses remain constant at $80,000 and sales increases to $160,000, profit margin will increase to {1 – $80,000/$160,000)} = 50%. Increasing the revenue by $200,000 more with constant expenses would increase profit margin till {1 – $80,000/$200,000)} = 60%. In a nutshell,  increasing sales lead to improved profit margins.

As per the above scenarios, we can generally infer that profit margin is improved by increasing sales and decreasing costs. Theoretically, a business can achieve higher sales by either boosting up the prices or the volume of units sold or even both.  Practically, price increase is possible just to the level of maintaining the competitive edge in marketplace, while the sales volumes stay reliant on market dynamics such as overall demand, market share percentage of the business, and existing position and potential moves of the business. Similarly, cost controls scope is also limited. One can reduce or remove a non-profitable product line to reduce expenses, it will also cause the business to lose out the corresponding sales.

In all stated scenarios, it is inferred that a fine balancing act to adjust pricing, volume and cost controls is required by the businesses. The profit margin essentially serves as an indicator of an adeptness of the business owners or management in executing the pricing strategies leading to the higher sales, and in controlling the different costs efficiently to keep them at minimal level.

Use of Profit Margin

Profit margin is used by all businesses; from billion dollar businesses to street level stall. Aside from individual businesses, profit margin is used to show the profitability capability of bigger sectors as well as national/regional markets. In short, profit margin is a globally adopted measure for profit generating ability of the business, which also indicates its future potential for the same.

Investors also evaluates the profit margin of the startup before investing into it.

Large companies raising money by issuing debts must also show their intended use of capital, which provides valuable insights to the investors regarding profit margin, achieved either via cost reduction or boosting sales, or both.

Profit margin is also an important indicator for equity valuations in primary market for the initial public offerings (IPO). It is one of the core figures reported by listed companies in their quarterly results.

Individual businesses should quote their profit margin to seek loan from the banks and other lenders, especially if the loan is being taken against any collateral.

Investors use profit margin analysis to compare the ventures they are interested in for investments, along with using other parameters.

It also reveals the business’s seasonal patterns and performance during different timeframes. For example, warm summers usually result in lower profit margin for the heater manufacturers, ending up with unsold inventory and declining sales.

Business owners, external consultants and company management to solve operational issues and improve business performance. For instance, negative or zero profit margin shows comparable for high expenses levels relative to sales. Moreover, it also helps determine the leaking areas – such as high unsold inventory, underutilized employees and excess resources, and high rentals – so companies can devise suitable strategies.

Companies with multiple business units, product lines, geographically spread out facilities and stores also use profit margin for measuring each unit’s performance and compare all.

However, profit margin is not the only factor for comparison since every business has its own kinds of operations. Generally business having low profit margin, like transportation and retail, experience high turnaround and revenue, ending them up with overall high profits irrespective of the low profit margin comparatively.  The luxury goods having low sales, but high profit per unit lead to high profit margin. Following example compares the profit margins of four long established and successful businesses from retail and technology space:

Technology businesses such as Alphabet and Microsoft  have high double-digit quarterly profit margins unlike the single-digit margins gained by Walmart and Target. However, it doesn’t imply that Target and Walmart did not produce profits or were less successful companies compared to Alphabet and Microsoft.

The stock returns between 2006 and 2012 show similar trends across these four stocks, though Google and Microsoft’s profit margin was quite more than Walmart and Target’s during the same period. Since they operate in different sectors, a blind comparison based just on profit margins can be inappropriate. Profit margin comparisons between Alphabet and Microsoft and between Target and Walmart is more appropriate.

Examples of High Profit Margin Industries

Businesses producing high end accessories and luxury goods often run on and low sales and high profit potential. Few expensive items, such as a high-end car, are ordered to manufacture– that is, the unit is produced after receiving an order from the customer, which makes it a  low-expense process having less operational overheads.

Gaming and software companies may invest initially while producing a particular software/game, and encash big later by just selling thousands of copies at minimal expenses. Getting into long term contracts with the device manufacturers, such as offering pre-installed Windows and MS Office on the Dell-manufactured laptops, the cost is further reduced while maintaining revenues.

Patent-secured businesses such as pharmaceuticals  usually experience high research costs in the beginning, but they reap huge high profit margins after selling the patent-protected medicines without any competition.

Examples of Low Profit Margin Industries

Operation-intensive companies such as transportation which deal with changing fuel prices, manpower’s perks and retention, and maintenance of vehicles, usually experience lower profit margins.

Agriculture-based businesses generally have low profit margins due to weather uncertainty, operational overheads, high inventory, need for storage and farming  space, and resource-intensive tasks.

Automobiles also experience low profit margins, as sales and profits are limited by uncertain consumer demand,  intense competition, and high operational expenses for developing dealership and logistics networks.

Conclusion

Since  sales and expenses are the two basic components for determining profit margin, it is recommended to use this to compare businesses operating in the same sector. As every industry follows diverse business models and sales streams and bears varying effects of seasons and occasions, profit margins should be considered with care for comparing these diversified businesses.

While profit margin just implies net margin, other similar variants to evaluate profit margins include gross profit margin, wherein the gross profit (revenue minus the cost of goods sold including materials. labor and overhead) by revenue generated, operating margin (or operating profit margin) which divides the operating profit (revenue minus selling, general and administrative expenses) by revenue, pretax profit margin that divides pretax earnings by revenue, and the net margin (or net profit margin) that divides net income or profits by total revenue. Researchers and investors tend to use multiple factors to draw meaningful inferences.

References for Profit Margin

Academic Research on Profit Margin

Using asset turnover and profit margin to forecast changes in profitability, Fairfield, P. M., & Yohn, T. L. (2001). Review of Accounting Studies, 6(4), 371-385.

The impact of brand equity on customer acquisition, retention, and profit margin, Stahl, F., Heitmann, M., Lehmann, D. R., & Neslin, S. A. (2012). Journal of marketing, 76(4), 44-63.

Profit margin and capital structure: an empirical relationship, Eriotis, N. P., Frangouli, Z., & Ventoura-Neokosmides, Z. (2002). Journal of Applied Business Research, 18(2), 85-88.

Market share, profit margin, and marketing efficiency of early movers, bricks and clicks, and specialists in e-commerce, Min, S., & Wolfinbarger, M. (2005). Journal of Business Research, 58(8), 1030-1039.

A diagnostic for earnings management using changes in asset turnover and profit margin, Jansen, I. P., Ramnath, S., & Yohn, T. L. (2012). Contemporary Accounting Research, 29(1), 221-251.

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