Profit Margin

Businesses and individuals across the globe perform for-profit economic activities with an aim to generate profits. However, absolute numbers - like $X million worth of gross sales, $Y thousand business expenses or $Z earnings - fail to provide a clear and realistic picture of a business’ profitability and performance. Several different quantitative measures are used to compute the gains (or losses) a business generates, which make it easier to assess the performance of a business over different time periods, or compare it against competitors.

Profit margin is one of the commonly used profitability ratios to gauge profitability of a business activity. It represents how much percentage of sales has turned into profits. Simply put, the percentage figure indicates how many cents of profit the business has generated for each dollar of sale. For instance, if a business reports that it achieved 35 percent profit margin during the last quarter, it means that it had a net income of $0.35 for each dollar of sales generated.

While proprietary businesses, like local shops, may compute profit margins at their own desired frequency (like weekly or fortnightly), large businesses including listed companies are required to report it in accordance with the standard reporting timeframes (like quarterly or annually). Businesses which may be running on loaned money may be required to compute and report it to the lender (like a bank) on a monthly basis as a part of standard procedures.

Profit margin is calculated by dividing the net profits by net sales, or by dividing the net income by revenue realized over a given time period. In the context of profit margin calculations, net profit and net income are used interchangeably. Similarly, sales and revenue are used interchangeably. Net profit is determined by subtracting all the associated expenses, including costs towards raw material, labor, operations, rentals, interest payments and taxes, from the total revenue generated.

Mathematically,

Profit Margin   = Net Profits (or Income) / Net Sales (or Revenue)

                               = (Net Sales - Expenses) / Net Sales

                               = 1- (Expenses / Net Sales)

Dividends paid out are not considered an expense, and are not considered in the formula.

Taking a simple example, if a business realized net sales worth $100,000 in the previous quarter and spent a total of $80,000 towards various expenses, then

Profit Margin    = 1 - ($80,000 / $100,000)

                               = 1- 0.8

                               = 0.2 or 20%

It indicates that over the quarter, the business managed to generate profits worth 20 cents for every dollar worth of sale. Let’s consider this example as the base case for future comparisons that follow.

A closer look at the formula indicates that profit margin is derived from two numbers – sales and expenses. To maximize the profit margin which is calculated as {1 - (Expenses/ Net Sales)}, one would look to minimize the result achieved from the division of (Expenses/Net Sales). That can be achieved when Expenses are low, and Net Sales are high.

Let’s understand it by expanding the above base case example.

If the same business generates same amount of sales worth $100,000 by spending only $50,000, its profit margin would come to {1 - $50,000/$100,000)} = 50%. If the costs for generating the same sales further reduces to $25,000, the profit margin shoots up to {1 - $25,000/$100,000)} = 75%. In summary, reducing costs helps improve the profit margin.

On the other hand, if the expenses are kept fixed at $80,000 and sales improve to $160,000, profit margin rises to {1 - $80,000/$160,000)} = 50%. Raising the revenue further to $200,000 with the same expense amount leads to profit margin of {1 - $80,000/$200,000)} = 60%. In summary, increasing sales also bumps up the profit margins.

Based on the above scenarios, it can be generalized that profit margin can be improved by increasing sales and reducing costs. Theoretically, higher sales can be achieved by either increasing the prices or increasing the volume of units sold or both. Practically, price rise is possible only to the extent of not losing the competitive edge in the marketplace, while sale volumes remain dependent on market dynamics like overall demand, percentage of market share commanded by the business, and competitors’ existing position and future moves. Similarly, scope for cost controls is also limited. One may reduce/eliminate a non-profitable product line to curtail expenses, but the business will also lose out on the corresponding sales.

In all scenarios, it becomes a fine balancing act for the business operators to adjust pricing, volume and cost controls. Essentially, profit margin acts as an indicator of a business owners’ or management’s adeptness in implementing pricing strategies that lead to higher sales, and in efficiently controlling the various costs to keep them minimal.

From a billion-dollar publicly listed company to an average Joe’s hot dog stall operating on the street, the figure is widely used and quoted by all kinds of businesses across the globe. Beyond individual businesses, it is also used to indicate the profitability potential of larger sectors and of overall national or regional markets. It is common to see headlines like “ABC Research warns on declining profit margins of American auto sector,” or “European corporate profit margins are breaking out.”

In essence, profit margin has become the globally adopted standard measure of profit-generating capacity of a business, and is a top-level indicator of its potential.

• Investors looking at funding a particular startup may like to assess the profit margin of the potential product/service being developed
• Large corporations issuing debt to raise money are required to reveal their intended use of collected capital, and that provides insights to investors about profit margin that can be achieved either by cost cutting or by increasing sales or a combination of both
• The number has become an integral part of equity valuations in the primary market for initial public offerings (IPO)
• It is among the first few key figures to be quoted in the quarterly results reported by listed companies
• Individual businesses, like a local retail store, may need to provide it for seeking (or restructuring) loan from banks and other lenders. It also becomes important while taking loan against business as collateral.
• It is used by investors while comparing two or more ventures for investments to identify the better one, in addition to using other parameters
• It is used to study seasonal patterns and performance of business during different timeframes. For instance, warm winters may lead to lower profit margin for a heater manufacturing company as it may end up with unsold inventory amid declining sales

However, profit margin cannot be the sole decider for comparison as each business has its own distinct operations. Usually all businesses with low profit margin, like retail and transportation, will have high turnaround and revenue which makes up for overall high profits despite the relatively low profit margin figure. High end luxury goods have low sales, but high profit per unit make up for high profit margin. Below is a comparison between profit margins of four long-running and most successful companies from technology and retail space:

Data Source: YCharts.com

Technology companies like Microsoft and Alphabet have high double-digit quarterly profit margins compared to the single-digit margins achieved by Walmart and Target. However, it does not mean Walmart and Target did not generate profits or were less successful businesses compared to Microsoft and Alphabet.

Graph Courtesy: Yahoo! Finance

A look at stock returns between 2006 and 2012 indicate similar performances across the four stocks, though Microsoft and Google's profit margin were way ahead of Walmart and Target's during that period. Since they belong to different sectors, a blind comparison solely on profit margins may be inappropriate. Profit margin comparisons between Microsoft and Alphabet, and between Walmart and Target is more appropriate.

• Businesses of luxury goods and high end accessories often operate on high profit potential and low sales. Few costly items, like a high-end car, are ordered to build – that is, the unit is manufactured after securing the order from the customer, making it a low-expense process without much operational overheads.
• Software or gaming companies may invest initially while developing a particular software/game, and encash big later by simply selling millions of copies with very little expenses. Getting into strategic agreements with device manufacturers, like offering pre-installed Windows and MS Office on Dell-manufactured laptops, further reduces the costs while maintaining revenues
• Patent-secured businesses like pharmaceuticals may incur high research costs initially, but they reap big with high profit margins while selling the patent-protected drugs with no competition.

• Operation-intensive businesses like transportation which may have to deal with fluctuating fuel prices, drivers’ perks and retention, and vehicle maintenance usually have lower profit margins
• Agriculture-based ventures usually have low profit margins owing to weather uncertainty, high inventory, operational overheads, need for farming and storage space, and resource-intensive activities.
• Automobiles also have low profit margins, as profits and sales are limited by intense competition, uncertain consumer demand and high operational expenses involved in developing dealership networks and logistics.

Since revenue and expenses are the two key ingredients for computing profit margin, it is suggested to use this figure to compare businesses within the same sector. As each industry sector follows different business models and revenue streams and each has varying impacts of seasonal effects, care should be taken while looking at profit margins for comparing diversified businesses.

While profit margin simply refers to net margin, other similar variants that are checked for assessing profit margins include gross profit margin which divides gross profit (revenue minus the cost of goods sold including labor, materials and overhead) by revenue earned, operating margin (or operating profit margin) which divides operating profit (revenue minus selling, general and administrative expenses) by revenue, pretax profit margin which divides pretax earnings by revenue, and net margin (or net profit margin) which divides net income or profits by total revenue. Investors and researchers look at a combination of such multiple factors to draw meaningful inferences.