For a business to survive in the long term it
must generate profit. Therefore the net profit margin ratio is one of the
key performance indicators for your business. Profit margin is used as a
measure of how much a company actually retains in earnings per dollar of
revenue from sales of goods or services. It is one potential measuring
stick of profitability. The term has various other names, such as net
profit margin, net profit ratio, or simply net margin.
Profit margin is simply calculated by finding the net profit as a
percentage of the revenue.
Net Profit margin = Net profit (after taxes) /
Revenue * 100
A 20% profit margin, for example, means the company has a net income of
$0.20 for each dollar of sales.
Profit margin can be useful for comparing or contrasting companies that
are within similar industries, but cross-industry comparison may not be as
beneficial as profit margins vary greatly depending upon the involved
industry. A higher profit margin indicates a more profitable company that
has better control over its costs compared to its competitors. A low
profit margin can indicate pricing strategy and/or the impact competition
has on margins.
Profit margin can also be helpful as simply looking at earnings may not
tell as much of a story. Even increased earnings may not mean the
company's financial situation is improving if costs have increased by the
same amount or more. Increased earnings are good, but an increase does not
mean that the profit margin of a company is improving. For instance, if a
company has costs that have increased at a greater rate than sales, it
leads to a lower profit margin. This is an indication that costs need to
be under better control.
Imagine a company has a net income of $10 million from sales of $100
million, giving it a profit margin of 10% ($10 million/$100 million). If
in the next year net income rises to $15 million on sales of $200 million,
the company's profit margin would fall to 7.5%. So while the company
increased its net income, it has done so with diminishing profit margins.
Here are a few examples of the net profit margins from the same
Leisure & Hotels International Airline Manufacturer Retailer Discount
Airline Refining Pizza Restaurants Accounting Software
Net Profit 7.36% 4.05% -10.48% 1.63% 10.87%
12.63% 7.55% 27.15%
Just like the gross profit margins, the net profit margins also vary from
business to business and from industry to industry. When we compare the
gross and the net profit margins we can gain a good impression of their
non-production and non-direct costs such as administration, marketing and
We saw that the international airline's gross profit margin was the lowest
of this group of eight businesses at only 5.62%; but look, its net profit
margin is 4.05%, only a little bit lower than its gross profit margin. On
the other hand, the discount airline's gross profit margin is 27.46% but
its net profit margin is a lot less than that at 10.87%. As we just said,
these comparisons give us a great insight into the cost structure of these
Look at the software business too, a very high gross profit margin of
89.55% but a net profit margin of 27.15%. This is still high, but we can
now see that the administration and similar expenses are very high whilst
its cost of sales and operating costs are relatively very low.
It is worth analyzing the ratio over time. A variation in the ratio from
year to year may be due to abnormal conditions or expenses. Variations may
also indicate cost blowouts which need to be addressed. A decline in the
ratio over time may indicate a margin squeeze suggesting that productivity
improvements may need to be initiated. In some cases, the costs of such
improvements may lead to a further drop in the ratio or even losses before
increased profitability is achieved.