The four types of profit margin

Posted on Wednesday, August 7th, 2019 MarketBeat Staff

Summary - The ultimate, or bottom line, metric for a business of any size is how profitable they are. Profit is a measurement that is different from sales or revenue. Profit margin is a measurement of how many cents a company can retain from every dollar of sales that is expressed as a percentage. For public companies, the earnings report they are required to release every summer allow investors to review their balance sheet, income statement and other financial statements to determine if a company is profitable, and if so how profitable they are.

There are four main types of profit margin. The most commonly used is net profit margin, which is also known as net income or the bottom line. The other types are gross profit margin, operating profit margin, and pre-tax profit margin. A simplified look at this is as follows:

  • Gross profit margin minus indirect variable costs (facilities, advertising, R&D, etc.) equals the operating profit margin.
  • Operating profit margin minus interest on debt equals pre-tax profit margin.
  • Pre-tax profit margin minus taxes equals net profit margin

Every business has a different standard to decide what investors will consider a good profit margin. One of the considerations is the sector that the company is in. For example, companies in the retail sector will operate with lower profit margins than some technology companies. For this reason, investors need to make sure they are comparing businesses of roughly the same size and within the same sector when making evaluations.

Introduction

A business can have an innovative concept, beautifully designed products, perform a vital service. But the question for investors eventually comes down to a simple question … how profitable are they? The ability of a business to make a profit (i.e. the bottom line) is fundamental to predicting success. However, not all profit is the same. To help assign a meaning between the profitability of two companies, it is useful for investors to calculate a company's profit margin, which is the focus of this article. In this article, we'll define what profit margin is, review the four different types of profit margins, and look at the limitations of calculating profit margin.

What is the profit margin?

Profit margin is one of the most commonly used profitability ratios that help investors understand what percentage of their sales has become profitable. It is commonly explained as the number of cents a company generates for every dollar of sales. A profit margin of 25% means that it had a net income of $0.25 for every dollar of revenue generated. Profit margin comes down to the relationship between sales and expenses. In its simplest form, the way for a business to increase their profit margin is to increase sales while reducing the expenses that are required to create the product. As a small company increases its production, they may begin to generate higher profits through economies of scale. In this sense, the profit margin is a way to look at the efficiency of a company.

Profit margin is different from the revenue

A company's revenue tells investors how much money a company makes. Profit is about how much money a company keeps, and subsequently how much cash a company has available to re-invest in their company, to buy back shares (which will raise their stock price) or to return to shareholders in the form of dividends. Profit takes into account things like the cost of goods sold and other factors such as overhead costs.

For example, let's say Company A sells 100 of their products at $80 each. The company's revenue would be $8,000 (100 x 80). However, let's say each product costs the company $60 to make. Their profit would be $2,000. Let's say also they had $1,000 in additional costs that went into the selling of their product. Their final profit would be $1,000.

Profit margin is also different from markup

Margin vs. markup is often confused. Markup is the amount by which the cost of a product is increased to arrive at a selling price. For example, if a product sells for $50 and costs $30 to manufacture, the markup is $20. However, the markup stated as a percentage is 66% since it is the markup amount divided by the product cost. However, the profit margin is 40% since it is calculated as the margin divided by sales. Since the basis for calculating markup is a cost rather than revenue, for a business to generate the particular margin they want, they have to markup the cost of the product by a percentage greater than the margin.

The four types of profit margin

Businesses can calculate profit in four different ways. All of them are valid in their way. The most common way of calculating profit is by using the net margin. Net margin takes into account everything from the cost of making the profits to interest payment on debt and tax payments. This gives investors what is known as net income or the "bottom line". Net margin shows investors the worst-case scenario for a company. However, younger, growth-oriented companies may not be profitable at first. If not, investors will pay close attention to the company's sales and revenue projections to determine when they will become profitable.

The most basic measurement of a company's profit is gross profit. Gross profit only takes into account the immediate cost of developing its products. Let's look at a basic example of how to calculate gross profit margin. If a company sells a product for $100 and it costs them $50 to make the product (i.e. cost of goods sold), then they will make a gross profit of $50 for every product sold – a 50% gross profit margin.

However, companies have other costs associated with their business aside from the raw materials that are required to make their product. These operating expenses include labor costs, overhead costs from their facilities, the cost of research and development as well as advertising and marketing costs. When these costs are factored in, it determines the operational margin. In our example above, the company may have $20 of additional operating costs for every $100 product sale. This means their operating profit margin is 30% [$100 – ($50 + $20)].

Another cost to a business is interest payment that they make on their debt. Many growth companies use debt to help finance their growth. When the company adds that cost to their operating profit margin they come up with their pre-tax profit margin. Let's say the company in our example added $10 of interest payments to every $100 sale. Their pre-tax profit margin is 20% [$100 – ($50 + $20 + $10)].

Finally, a business has to pay taxes. When that number is deducted from the pre-tax profit margin it leaves the net profit margin or bottom line number. That means a company's revenue with all costs deducted.

As you can see, the net profit margin is the most conservative measurement of a company's profit.

Limitations of analyzing profit margin

Profit margins will be very different between sectors of the economy. Even within the same sector companies have different business models. For example, a luxury brand may be less willing to discount its products while a "mass" brand may use heavy discounting to drive volume. For this reason, it's important that, for comparison purposes, investors should use companies within the same industry that have similar revenue numbers and business models when trying to assess the financial health of a company. A growing company may not be generating any profit, but may still be a worthwhile investment.

The final word on profit margin

From the home business that pays out more in inventory than it brings in through sales to the corporation that continues to post a negative net income, the most fundamental measurement of a company's success is profit. A company's profit is a measurement of how much money they retain on every sale. The profit margin expresses this as a percentage.

Profit is different from revenue. Many companies generate a substantial amount of revenue but have nearly equally substantial expenses which make them less profitable. The key to generating profit is for a company to be able to increase their revenue while lowering their overall expenses. Companies develop pricing strategies that seek to maximize this efficiency between gross sales and the cost of generating that revenue.

Comparing profit margins between two companies can be tricky because one sector may have higher expenses that are considered typical of their industry. For this reason, investors should be less concerned about a company's profit margin as a stand-alone number but rather how their profit margin relates to similarly sized companies in their sector.

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