Good profit margin is one of the key factors that are necessary for a business to grow and for the owners of the company to generate a steady cash flow. The main indicator that gives an understanding of the bottom line is the net profit margin.
But economists calculate a few more auxiliary values. The purpose of such a step is to assess the company’s situation from different perspectives.
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What is Profit Margin?
The profit margin, or the profit margin ratio, is a measure that shows the share of profits in a company’s total revenue. It is expressed as a percentage.
In a simple form, it can be said that the profit margin represents the efficient use of the resources that a company uses to produce its goods.
Why is Profit Margin Ratio Important?
In practice, a company’s profit margin shows how many cents of every dollar earned is turned into revenue by business owners.
This ratio reflects the company’s financial health, the correctness of its pricing and the existence of problems in its business model.
If the profit margin falls below the industry average, it is a sign that the approach to business needs to be revised. The problem may lie in the pricing system or in inefficient use of resources.
Good profit margin is perceived by investors as an indicator of a company’s high potential. It can be used to compare large, medium and small businesses in terms of their ability to generate revenue.
How is Profit Margin Calculated?
Economists distinguish several types of profit margins that can be used to assess a company’s financial metrics.
Gross Profit Margin
This is the easiest indicator to calculate. The formula for calculating the gross profit margin is given below.
Gross profit margin = ((Revenue – cost of goods sold) / revenue) x 100%.
A more simple form of the formula is: Gross profit margins = (gross profit / revenue) x 100%.
Revenue is the total sales revenue generated by the company before any expenses are deducted. Another term used to refer to the denominator is net sales. This is gross sales minus returns, rebates, discounts, etc.
The cost of goods sold includes:
- the direct costs of manufacturing the product (purchase of raw materials, etc.)
- labour costs of employees;
- overhead costs associated with production, e.g. depreciation of equipment (each business determines which costs to include in this category.
Suppose a company has received total revenue of $5000 for a product with total production costs of $3500. In such a case, the company’s gross margin is 30%.
To say whether that figure represents a healthy profit margin, one must compare it to the industry average.
For example, for the restaurant business, the average profit margin is below 10%. But in the consultancy business, this figure easily exceeds 80%.
Operating Profit Margin
This is a more accurate measure of a company’s profits because the calculating operating profit margin takes into account not only the cost of manufacturing products, but also other indirect costs that fall into the company’s operating expenses (OPEX) category.
To calculate this indicator, operating profit is used. Sometimes EBIT is substituted for it in the operating profit margin formula.
The difference between these ratios is that operating profit, unlike EBIT, does not include income and expenses that are non-recurring and unrelated to the company’s operating activities (e.g. profit from the one-off sale of part of fixed assets).
Operating profit margin = ((revenue – cost of goods sold – operating costs) / revenue) x 100%.
In simpler terms, the formula can be written as follows:
Operating profit margin = (operating income/revenues) x 100%
If we take $500 as the operating expense in the example above, then the company has an operating profit of $1000 ($5000 – $3500 – $500). And the operating margin is 20%.
Net Profit Margin
Net profit is what remains of the company’s revenues after accounting for all costs, including debt service, taxes, etc. You can find this figure at the end of the company’s income statement.
The profit margin net helps assess the ability of a business to pay dividends. The higher this indicator, the better the company’s situation.
The formula below can be used to calculate gross profit margin net.
Net profit margin = ((Revenue – cost of goods sold – operating expenses – other expenses – interest – taxes) / Revenue) x 100%
The Net Profit Margin Formula can be simplified into the following form:
Return on Net Income = (Net Income) / Revenue) x 100%
If the company with $5000 of revenue in the example above has a net profit of $200, then its net profit margin will be 4% ((200/5000)*100%).
What’s The Difference Between Your Gross, Operating, and Net Margins?
Each of the profit indicators provides a different perspective on a company’s performance. Taken together, they provide a complete picture of the strengths and weaknesses of a business:
- gross profit margin demonstrates the ability of the business to generate revenue;
- operating margin shows whether a company is generating profits from sales, revealing excess operating costs, lack of productivity;
- net profit margin shows the efficiency of the business as a whole.
Understanding the financial processes relating to all levels of earnings helps management develop strategies to improve business operations, sales and financial performance. An investor can use these indicators as one of the criteria for selecting the most promising company in the industry.
How Do You Analyze Profit Margin Ratio?
A profit margin analysis is necessary to see how well the company’s assets are allocated and to find areas where costs need to be reduced.
If a company offers several products, by performing a margins analysis, management can evaluate each component of the range in terms of profit margins.
An analysis of the profit margin should be carried out taking into account 2 factors:
- the average values for the industry in which the company operates;
- results that have been shown in previous years.
Low profit margins compared to competitors most often indicate an incorrect approach to direct cost management and inappropriate pricing. The exception is deliberate dumping, which a company resorts to in order to gain market share.
If net profit margins are gradually decreasing, it is a sign that it is time for the company to cut costs. It may also indicate that there is a surplus of unprofitable items in the product range.
If the net profit margin remains unchanged while revenues increase, this is an indication of inflated non-production costs.
Rising profit margin is a positive signal, indicating efficient cost management.
Profit Margin Ratio Example
As an example, let’s look at two companies over the course of two years.
Let’s say company A made a net profit of $100k and revenue of $750k in the first year. The net profit margin was 13.3%. And the next year the same indicators were $120 thousand, $950 thousand and 12.6%.
Such dynamics demonstrate that the company’s expenses grow faster than its incomes. It may be due to the introduction of a new, less profitable product or to management mistakes.
Another example, company B. Let’s say it had similar results in the first year. In the second year, it made a net profit of $80k on revenue of $550k. In this case, the calculating net profit margin increased to 14.5%.
This figure should be evaluated positively, because the company was able to make a good profit by converting a larger portion of its sales into revenue than in the previous year.
What is a Good Profit Margin?
According to New York University, the average net profit margin of US companies is 8.89%.
The benchmarks for estimation are as follows:
- 5% – low score;
- 10% – good score;
- 20% – excellent achievement.
But these are universal figures and it makes no sense to use them in the evaluation of a single company. There are low-margin industries as well as high profit margins businesses.
For example, grocery shops and other retailers’ profit margin varies from 20% to 40% andnet profit margins vary from 0.64% to 8.67%, depending on the characteristics of the products they sell. In most cases, this figure cannot be high because of the numerous costs involved. Also industries with high competition are characterized by low rates.
High margin businesses include consultancy and software sales. Such companies have lower costs, do not need to rent significant space, do not incur costs associated with product storage, etc. A good gross profit margin for such a business would be one that tends towards 100%.
Another factor that affects the profit margin is the size of the business. The smaller the company, the higher the figure should be. Large corporations incur significant costs for management personnel and other overheads.
Even the location of a company has an impact on what is considered a healthy ROI. This is because wage levels, rental costs, etc. vary from state to state.
Profit Margins By Industry
Here is a table of the profits margin data that NYU published in January 2023.
What Business Has The Best Profit Margin?
According to New York University, regional banks are the undisputed leaders. In 2022, they posted a net margin of 30.31%.
Other niches characterized by higher profit margins include:
- Transportation (Railroads) — 27.65%;
- Bank (Money Center) — 26.96%;
- Financial Svcs. (Non-bank & Insurance) – 26.32%;
- Oil/Gas (Production and Exploration) — 26.01%;
- Utility (Water) — 25.12%.
But this is an average figure, obtained by adding up the results of dozens of companies. In every industry, there are companies that show what is a good profit margin (above average) and those whose business is much worse.
What Industry Has The Lowest Profit Margin?
There are industries in which, with investor money or government subsidies, companies can operate for a long time at a loss rather than a profit. The lowest net profit margin (maximum loss) in the US is in the Software (Internet) category. It is -19.07%.
When it comes to profitable sectors of the economy with lower profit margins than the national average, those in the US would be:
- Electronics (Consumer & Office) — 0.54%;
- Retail (Online) — 0.64%;
- Drugs (Biotechnology) — 0.65%.
Even a negative net profit margin does not mean an imminent demise of the company. Instead, it is characteristic of a young business that is still conquering the market. A good example is Amazon, which has gone from losses to huge profits.
How To Increase Your Profit Margin
There are 2 ways to influence the profit margins. The first is to revise the pricing system and product range to increase revenues. The second is to reduce costs.
Increase Prices
Many small business owners are hesitant to take this step because they rightly fear losing market share. However, the costs of doing business are constantly increasing, which means that prices cannot remain unchanged.
If the demand for the goods or services offered by the company is growing and the business needs new capacity to develop, raising prices is an inevitable step.
Decrease Expenses
This is the most obvious way to get a good profit margin. In the first instance, it is advisable to reduce the following types of business expenses:
- on raw materials and consumables by finding new suppliers;
- product delivery by eliminating fragile parts of the range or by setting up an in-house courier service;
- insurance, equipment repairs, business software, etc.
Alternative offers from suppliers should be analysed regularly to ensure that the company is taking advantage of the most favourable options.
Increase Sales
All costs of any company are made up of 2 components. This is the variable part, which depends on the quantity of output (or services provided) or direct costs.
There is also a constant cost component. It does not depend on the volume of sales, but it reduces profits. The more products the company sells, the less significant the fixed costs become (assuming that there is no need to increase production capacity to create one more conditional unit of product etc.).
Therefore, reducing the share of fixed costs in unit costs is one way to get a good profit margin.
Focus On High-Margin Products
One way to improve the profit margin is to calculate the margin earned on each of the products. The least marginal services and products should be excluded from the range if they are not key, or consideration should be given to increasing the price/reducing the costs of such products.
Retain Customers With Loyalty Programs
This is one way to improve net profit margin by reducing advertising costs while maintaining sales volume. Statistical studies prove that it costs a company 5-25 times less to retain an existing customer than to attract a new one.
Loyalty programmes can also be useful in increasing sales. One way to encourage customers to buy more is to create a discount system linked to the number of purchases or the amount spent on the company’s goods/services.
FAQ
Is 60% profit margin good?
In general, the answer is yes. A gross profit margin of 60% is an excellent result for most industries except banking and finance.
On average, a good gross profit margin is 50-70%.
Is the profit margin ratio better high or low?
The higher the profit margin, the better for the company. This is considered to be a sign that the company’s business is more efficient than that of its competitors. But one should only speak of what is a good profit margin within a single industry.
A bank with a higher figure cannot be considered a more efficient company than a shop that will have a much lower profit margin. The reason for this is that different margins are considered healthy for each sector of the economy.
Is a higher profit margin ratio good?
Yes. Owners should strive to increase the business’s profit margin. The higher the figure, the more profit each good/service sold generates.
A good profit margin is above the industry average.
What is a bad profit margin ratio?
A negative net profit margin is considered to be a bad indicator. It means that the company is making a loss from its activities rather than income. Such a situation cannot be considered a sustainable business model and requires radical improvements.
It is also bad if the profit margin ratio is noticeably lower than the industry average or has been declining for several years.
What profit margin is too high?
There is no such a thing as too high a profit margin in business. Companies are striving to get it as high as possible.
A markedly higher net profit margin than competitors may be the result of overpricing. But if customer demand persists in the face of rising profit margins, it is more likely to be due to a sound approach to cost and assortment management.
What is a reasonable profit margin for a small business?
Generally speaking, a good net profit margin is in the 7-11% range. But individual sectors will be the exception. For example, the would-be small business owner should realise that such figures are unlikely to be achievable for retail. At the same time, in high-margin business segments (such as investment and asset management), they will fail.
What are the average profit margins by industry?
Based on data released by New York University in early January 2023, the average gross profit margin in the US is 36.28%. The average net profit margin is 8.89%.
Excluding the financial sector, these figures are slightly lower at 33.19% and 7.77% respectively.
The bottom line
A good profit margin compared to competitors is an indicator of the stability of a business and its attractiveness to investors.
Net profit margin is one of the key indicators that both business owners and shareholders should keep an eye on. The ideal situation is considered to be one of gradual growth over the years.
