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How Are Profit Margins Defined and Measured?


As a business owner, your profit margins may be key to making money and  growing a company. Evaluating your profit margins can assist you with gauging the financial health of your company. In order for your business to succeed, you may need to earn enough to turn a profit and reinvest into your company. This is where profit margins come into play.

Profit Margins Defined

Profit margins measure profitability as a percentage on a company’s income statement. A larger percentage indicates better performance. Ideally, you want revenue much higher than expenses paid.

For instance, a company with a profit margin of 20% is highly profitable. A company with a profit margin of 0.05% may need to make adjustments to improve their profitability. According to the American Enterprise Institute, the average profit margin for a U.S. company is 7.9%. However, that average may vary across industries.

What Is Profit?

Profit, also known as net income, is the money you make after deducting the money you spent on business expenses. Many publicly traded companies calculate profit quarterly basis and issue their earnings report after the quarterly calculation is complete. That earnings report is a company’s benchmark for profit and loss.

Profit can indicate if a company is performing optimally. If profits are  high, management may be doing a great job minimizing expenses. High profits could also point to marketing strategies that result in higher sales. If profits are low or nonexistent, the company may be facing financial difficulty. There may be weak demand as a result of management issues or poor sales techniques.

What Is Revenue?

Profit measures the cash remaining after you pay your business expenses. Revenue is total business income before expenses, which is not an accurate measurement of a company’s performance.

Having money coming in is great, but if you’re spending more than you’re earning, you may face financial difficulties.

How to Measure Profit Margins

What are profit margins and how do you measure them?

Profit margins are measured by up to four calculations. Gross profit margins and net profit margins are standard, but operating profit margin and pretax profit margin are factors as well.

Gross Profit Margin

Accountants use gross profit margins to determine if a business’s pricing strategy is profitable. Dividing gross profit (revenue minus the cost of production) by revenue earned can help a business adjust its pricing.

Operating Profit Margin

The operating profit margin divides operating profit (revenue minus sales and administrative expenses) by revenue, but leaves a few essential items out of the equation. While it includes operating costs and the costs of goods sold, it doesn’t account for financial costs like taxes.

Pretax Profit Margin

Pretax margins simply divide pretax earnings by revenue. This can help determine the impact of local and federal tax on your business’ bottom line.

Net Profit Margin

A company’s net profit margin measures its total profitability. A high net profit margin is likely great news for a thriving company. A low net profit margin can indicate issues including high costs

Net profit margins measure the total profitability of a company. A high net profit margin suggests the company is moving in the right direction. A low net profit margin may indicate potential problems including high costs or weak sales.

To calculate a net profit margin, divide the company’s net income into total revenue and then multiply by 100. For example:

A company’s total revenue is $200,000

The company’s total expenses are $160,000

The company’s net profit is $40,000

The total net profit margin is ($40,000/$200,000) x 100 = 20%

Profit Margin in the Marketplace

Luxury cars and bespoke clothing have low sales, but high profits. High prices help, but companies and designers that only make products after taking customer orders reduce overhead.

Meanwhile, if you run a delivery service or cab company that is affected by the price of a gallon of gas, your margins are likely to be low. Though agriculture and automobile companies can succeed on a large scale, they often do so with low profit margins affected by multiple variables.

While high profit margins can drive huge sales in software and patented pharmaceuticals, low profit margins can drive companies straight out of a country. Outsourcing to a less-expensive labor market might seem callous, but it can increase a company’s profit margin by reducing labor costs.

Bottom Line

What are profit margins and how do you measure them?

It’s important to understand the impact profit margins have on your company’s performance. f you want your company to prosper for years to come, perhaps take a close look at your profit margins and compare them to those of similar companies. This could allow you to make adjustments when necessary.

Profit Tips

  • Finding a financial advisor who understands business finances doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • In-depth budgeting is a worthwhile strategy to adopt if you’re looking to improve your long-term finances. It may, however, be difficult to build a budget if you have little to no experience doing so. To get some help, stop by SmartAsset’s budget calculator.

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