Profit margin is the profit a company earns as a percentage of its revenue. Simply put, it indicates how many cents of profit the business has generated for each dollar of sale. Companies use this margin as a measure of profitability. The higher the it is the more money the company keeps.
Gross profit margin
Gross profit margin takes into account costs that are directly related to the production or acquisition of products or services. This includes the cost of materials, labour and storage – so-called “cost of goods sold” (COGS). It doesn’t include indirect fixed costs such as rent and utilities. Gross profit margin is calculated using the following formula:
Gross profit margin = (Revenue – COGS) / Revenue x 100
Operating profit margin
This type of profit margin includes the COGS and selling, administrative and overhead costs – the operating costs. It doesn’t account for debt, taxes and other non-operational expenses. Operating profit margin is calculated using the following formula:
Operating profit margin = (Revenue – operating costs) / Revenue x 100
Net profit margin
Net profit margin is the total amount of revenue left after subtracting all expenses. It is the most used of the three, also known as the bottom line. Net profit margin is calculated using the following formula:
Net profit margin = (Revenue – all costs) / Revenue x 100
Profit margins are usually calculated for a specific period such as a year or quarter. When comparing annual or quarterly profit margins, companies can see if their profitability is rising or falling and take action if needed. Investors also use profit margins to compare different companies. However, it is important to keep in mind that margins differ by industry. For example, the car industry has a low profit margin since the competition is intense. Pharmaceutical companies, on the other hand, have a high one because their products are patented.