Profit Margin

Reviewed by Annapoorna | Updated on Aug 27, 2020

What is Profit Margin?

Profit margin is one of the profitability measures that is widely used to gauge the degree to which a corporation or enterprise is making money. It reflects what percentage of revenue is profits. The percentage figure shows how many cents of profit the company has generated for every dollar of sales.

There are many different forms of margin for benefit. However, in daily usage it typically refers to the net profit margin, the bottom line of a business after all other costs, including taxes and one-off chances, were taken out of sales.

Understanding the Profit Margin & its Dynamics

Many different objective metrics are used to quantify the profits (or losses) a company produces. It is easier to determine a company's success over various periods or to compare it to competitors. Those measurements are known as profit margin.

The proprietary entities, such as local shops, may measure profit margins at their preferred frequency (such as weekly or quarterly). Whereas, the large firms and listed firms are forced to report it in compliance with standard reporting schedules (such as quarterly or annually).

The profit or profit margins are four levels: gross profit, operating profit, pre-tax profit, and net profit. These are reflected in the following sequence on a company's income statement: A company receives sales revenue and then pays direct costs of the service product. What remains is the profit margin.

Then it pays indirect costs such as company headquarters, advertising, and research and development. What is left is the operating margin. Then it pays interest on loans, adding or subtracting any extraordinary costs or inflows that are unrelated to the core sector of the company with a pre-tax margin left over. Instead, it pays taxes, leaving the profit surplus, also known as net income, which is the very crux of the matter.

Determinants of Profit Margin

Two numbers determine the profit margin — sales and expenses. To maximise the profit margin calculated as {1-( Expenses / Net Sales)}, the result of the division of (Expenses / Net Sales) would be sought to be minimised. That can be achieved when there are low expenditure and high net sales.

It can be generalised that by rising revenue and reducing costs, the profit margin can be increased. Theoretically, it is possible to achieve higher sales by either raising prices or increasing the volume of units sold, or both.

In practice, price rises are only possible to the degree that they do not lose the competitive edge of the competition. However, sales volumes remain dependent on market conditions such as total demand, the percentage of the market share regulated by the company, and the current position of competitors and potential movements. Similarly, there is also limited scope for cost controls.