Net profit margin and gross profit margin are common terms used in business. Both of them measure the success of profit-generation of your various business activities. As a business owner, your goal is to make a profit. However, simply keeping track of your total sales and expenses does not accurately measure your business’s profitability, and in effect, performance.
Luckily there are different quantitative measures you can use to compute your company’s generated gains or losses. They give an accurate overview of your business performance, both over a period of time and against your competitors. Profit margin is one such measure.
Profit margin is one of the most commonly used profitability ratios in the business world. It measures the degree of “success” a company or business has in terms of generating income. The profit margin is usually expressed in percentage. In other words, when we talk about profit margin, we basically ask the question, “For every £ of sale I make, how many cents do I take home?”
Four Levels of Profit
There are four levels of profit or profit margins (PM): gross profit, operating profit, pre-tax profit, and net profit. Today we will focus on two levels–gross profit margin and net profit margin. But first, let’s run through all four levels for better understanding.
This is technically your total sales revenue minus the direct costs of your products and services. Basically, it is what’s left of your sales revenue after you paid for the cost of producing your goods and services.
This is your gross profit margin minus your indirect costs like rent, advertising, and R&D. It is what’s left of your profit after paying for other expenses necessary for your business operations but isn’t related to the production of your goods and services.
When you pay for interests on debts and add or subtract any unusual charges or inflows unrelated to your main business, this is your pre-tax profit margin. As the name suggests, at this level, you haven’t paid your taxes yet.
Once you pay all your production costs, bills, and dues, as well as your taxes, what’s left of your sales revenue is the net profit margin. In other words, it is the company’s bottom line or net income.
Now, let’s dive deeper into the question: what is gross profit margin and net profit margin?
Gross Profit Margin
Gross profit starts with your total sales. Then you take out costs directly related to creating or providing your goods and services. These costs are commonly called “cost of goods sold” or “cost of sales.”
Here’s the simple formula for computing GPM:
Gross profit margin (%) = [(Revenue – Cost of goods sold)/Revenue] x 100
This is done on a per-product basis. And it only makes sense; your business offers multiple products and services with different prices and different costs of production.
Aggregated gross profit margin paints the rawest profitability picture of your business. It is also the simplest measure of profit margin as it only takes into account your total sales revenue and the cost of sales. However, the gross profit margin is most useful in analyzing your business’s product suite.
Net Profit Margin
When people ask, “What’s the company’s profit margin?” they actually refer to the net profit margin. This is the most significant profit margin measure of all four levels.
The net profit margin is calculated by dividing the net income by revenue realized over a given time period. Most small businesses can opt to compute for the net profit in a frequency they desire weekly, monthly, or quarterly. However, for larger businesses, it is practical to report the net profit margin on a per-quarter basis. Companies with debts are required to submit a monthly net profit margin report to the bank or their debtors.
The net profit margin is the most significant of all four measures because it indicates what is left of the revenue after all the costs, bills, taxes, and other expenses have been taken out of it. In the context of profit margins, net profit and net income can be used interchangeably, and the same goes for sales and revenue.
Here’s the formula for computing net profit margin:
Net profit margin (%) = [(R – COGS – OE – O – I – T)/R] x 100
NPM = net profit margin
R = revenue
COGS = cost of goods sold
OE = operating expenses
O = other expenses
I = interest
T = taxes
Analyzing the Profit Margin Formula
Profit is directly affected by two factors: your sales and your expenses. In order to maximize your profit margin, let’s take a look at one simple equation:
To achieve a high-profit margin, you need a low expense to revenue ratio. In a nutshell, to gain maximum profit, your aim as the business owner is to reduce the company’s expenses and increase your sales. In theory, you can increase your sales either by raising the prices, increasing the volume of units sold, or both. However, a price increase should be done in the context of your competitive edge in the market. Sales volume, on the other hand, is dependent on market dynamics.
Your control over cost is also limited. Market dynamics dictate the prices on resources needed in production. Switching to cheaper materials must be done with caution, as it can compromise product quality. In some cases, for effective cost reduction, you can opt to discontinue products that are non-profitable.
Ultimately, increasing the profit margin is a matter of balance between price, volume, and cost control adjustment. The profit margin acts as a litmus test of your efficiency and adeptness in pricing strategies and cost control as a business owner or manager.
Wrapping it up
Profit margins are essential in ensuring your business activities are income-generating. It is also used by creditors, investors, and fellow businessmen as indicators of a company’s financial health, management skill, and growth potential. As typical profit margins vary by industry sector, knowledge is necessary in order to effectively use it for comparing figures with other businesses.
Daunting as these calculations might seem, they are necessary in order to ensure your business is going the right way. If you are not adept at such computations, don’t worry. Some businessmen have a good eye for innovation and provide solutions to a problem without much math talent. Do not be afraid to delegate. Hire an expert when you’re in doubt. After all, it takes a lot of teams to run a business properly.