The profit margin is a measure of profitability, which is a net profit ratio. It is the amount in which the generated revenue from the sales exceeds the incurred costs in the business. In simpler terms, it means the income earned through making the sales. Further simplifying, it can be said that it is total revenue minus the expenses.
Individuals and businesses around the globe carry out the for-profit business activities in order to earn handsome profit. The absolute numbers of the gross sales, $xyz earnings, or thousand business expenses are difficult to assess the business’ performance and profitability. Quantitative measures, such as profit margin formula, are used to assess the business’ performance fortnightly, weekly or monthly basis. Large business reports its profitability on an annual basis. However, the small business is required to compute and report the profit margin on a weekly or monthly basis.
Thus, the performance and profitability of the business are examined and recorded systematically and correctly.
Types of Profit Margins
There are four levels of profit margins. These include operating profit, gross profit, net profit, and pre-tax profit. All of these types of profit margins are reflected in the income statement sheets of the companies. They are explained one by one below:
1. Gross Profit Margin
Gross profit is defined as a metric analyst, which is used for the assessment of the company’s financial health. From product sales, the cost of goods sold is subtracted. This is how you get the leftover amount from product sales. This is called the gross profit margin.
Gross Profit Margin= Net Sales – COGS
Where: COGS = Cost of Goods Sold
2. Operating Profit Margin
The operating profit margin shows up the profit that is Company is making after making payments for the variable costs such as raw material, production, wages, etc. It is usually calculated before paying the taxes or interest rates. When different kinds of expenses, such as administrative, selling, and general costs, are subtracted from the company’s gross profit number, you get the operating profit margin. This is also known as the money before taxes and interests had been applied. It is mainly a profit that results from the company’s ongoing operations.
Operating Profit Margin = Operating Income
3. Pretax Profit Margin
The pretax profit margin is calculated to measure the operational efficiency of the Company. It is the ratio that tells us the percentage of sales that the business had made during the sales of the product. It is usually carried out before the deduction of taxes. The pretax margin is usually used for comparing the profitability of different industries in the same market.
In order to calculate the pretax margin, you will need to take the operating income, subtract the interest expense as well as adding the interest income. Then, the non-recurring items such as losses and gains from discontinued operations are added. Thus, you get the pretax profit margin.
4. Net Profit Margin
This is the most significant of all other types of profit margin. The net profit margin ratio formula is measured by the division of net profits by the sales profits. Or, it can also be calculated by the division of net profit by the revenue that is realized over a period of time.
Mathematically, Profit Margin Formula = Net Profits (or Income) / Net Sales (or Revenue)
= (Net Sales – Expenses) / Net Sales
= 1- (Expenses / Net Sales)
This is how the net profit margin is calculated in order to show the actual profits gained by a company.
The profit margin is the actual profit made by the company after cutting the costs and expenses.