What is the Definition of Profit Margins?

By: First Union | Date:

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What is the Definition of Profit Margins?

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A profit margin demonstrates how profitable a business is. So if you look at all of the revenue over a given period and then subtract out business expenses and other related costs, what you have left shows exactly what the company made for that quarter or year. This percentage of revenue that remains represents the profit margin for your company. A company owner must understand where their profit margin stands at any given time so that they have a clearer picture of how financially healthy the company is. In this article, we look at the definition of profit margin as well as the various types of profit margin that exist and why these are important for any business to track.

Different Types of Profit Margins

Generally speaking, there are two primary types of profit margins that businesses usually keep track of Gross and Net profit margins. Gross profit margin is most often used when trying to determine how profitable a single product or service is. In figuring out what their gross profit margin is, a company will take the price of that product and then subtract out the costs associated with making that product. They then take the resulting number and divide it by the product price. So for example, let's say a product's price is 100.00 and it costs the company 45.00 to make the product. The gross profit margin here would be 55%.

With net profit margin, we are looking at the profit margin for the entire company, not merely a single product. To figure out the net profit margin, you divide net income by net sales and then multiply by 100. So, in factoring in net profit margin, for instance, let's say that over one year a company's net income was 100k; their net sales totaled 350k. This means then that their net profit margin for that year was roughly 28%.

It's important to understand the various components associated with calculating the different profit margin types. Net income in the above example simply means the total revenue that a firm takes in minus their expenses. Such expenses can include debt payments, investments, taxes, insurance as well as other things. The net sales represent gross sales for a given period minus discounts and returns. A company's revenue shows the total amount generated as a result of sales but does not include any of the operating expenses. To make it easy, keep in mind, that most of the numbers needed for calculating gross and net profit margins can be found on your company's profit and loss statement.

Why You Need to Keep Track of Your Profit Margin

As seen, there are a couple of different types of profit margin formulas and calculations to keep track of; the key is to stay on top of these profit margin percentages as they can reveal a lot about your business as well as help you to make decisions moving forward. Below are a few reasons why knowing your profit margin is so crucial to the success of any firm.

  • Allows your business to grow: The goal of most companies is to grow. That said, keeping tabs on your profit margin can help you do just that. Knowing where your profit margin stands let you see where the company may be underperforming. It also allows you to see where you make be overspending. You can thus make the necessary adjustments.
  • It helps you to work out problems: If you can identify issues before they become full-blown problems, then you are a step ahead of the game. Understanding where your profit margin stands can help you to identify those issues early on.
  • Lenders need to know where your profit margin stands: If you are looking to procure a business loan, odds are pretty good a lender is going to want to see how profitable the business is. You could have a standout product, but if that product isn't making money and/or for some reason the business overall isn't very profitable your chances of getting a loan could be slim to none. Keeping track of your profit margins can better prepare you when it comes to getting the additional capital you need.

Improving Your Profit Margins

Most companies are striving for a good profit margin. Once you know what your profit margins are—both net and gross—then you have a blueprint of sorts for moving forward and trying to get the company on the right course, a profitable course. So how do you improve your profit margins…

  • Cut down on expenses: This is perhaps the most important thing you can do to better those profit margins. When you know where your profit margins are, then you have the information necessary to determine where costs can be cut. Of course, you don't want to sacrifice the quality of your products, but they're likely are places where you can scale back on expenses.
  • Get rid of certain products/services: When you know your gross profit margin, for example, you can see what those underperforming products/services are. It could be time to get rid of them and replace these with something that generates more revenue for the company.
  • Increase product offerings: If you are doing well with a certain product, it could be time to launch additional products within this line and thereby create more channels for incoming revenue. Particularly if you have a loyal customer base ready and willing to try your products, this could allow you to increase your profitability.
  • Raise prices: Many small business owners often struggle over whether or not to raise prices. While it is understandable, there are times when price increases are in order. Especially, if your profit margins aren't where they need to be, this could be a sign that your pricing is too low and thus hurting your business in the long run.

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