Ask any finance professional, and they will tell you that it’s important to understand your business margins.
Why? Profit margins are ratios that help tell you how well your business is doing by gauging profitability.
Calculating profit margin determines how much profit your business has earned on each sale of goods or services. So, if you hear that a corporation has reported that it had a 45% profit margin last quarter, that means it generated an income (or profit) of $0.45 for each dollar it generated in sales.
It sounds simple, but understanding profit margin is a little more nuanced than one calculation. Understanding which profit margin is right for your business will help you measure the correct outcomes for future success. Robust financials are critical for forecasting and budgeting, including setting Key Performance Indicators (KPIs) and Metrics to gauge success.
Here are some examples of ways profit margin can be calculated:
Contribution Margin: This calculation takes the difference between sales and the total variable cost of goods sold and then divided by sales. This margin makes it easier to see the direct impacts of variable expenses on the specific product produced or service offered. This can be really helpful if your company produces a range of products, for example, and wants to compare profitability on a per-product basis. Example: Sales $100,000 minus Variable CoGS $30,000=$70,000 or 70%.
Gross Margin: This is calculated by subtracting the total cost of goods sold (both variable and fixed costs) from sales and then divided by sales. This is typically used when assessing manufacturing divisions or service-based branches where identifying costs to specific products or services is more difficult. Example: Sales $100,000 minus Variable CoGS $30,000 minus Fixed CoGS $15,000=$55,000 or 55%.
Operating Margin: This is derived from subtracting the total cost of goods sold and operating expenses (i.e., general and administrative costs) from sales. It’s also sometimes known as the Earnings Before Interest and Taxes (EBIT). The Operating Margin is useful when figuring out what funds are available for repaying debt and equity holders or taxes. This margin measures the operational efficiency of the business. Example: Sales $100,000 minus Variable CoGS $30,000 minus Fixed CoGS $15,000 minus Operating Expenses $30,000=$25,000 or 25%.
Pre-Tax Margin: To find out what the profit margin is before taxes, this calculation is a little more complex. The operating income, less interest expenses and plus interest income, is adjusted for any one-time gains or losses (i.e., discontinued manufacturing at one site) and gives Earnings Before Taxes (EBT). Then, EBT is divided by revenue to get the Pre-Tax Profit Margin. Example: Sales $100,000 minus Variable CoGS $30,000 minus Fixed CoGS $15,000 minus Operating Expenses $30,000 minus Net Interest Cost $20,000=$5,000 or 5%.
Net Margin: This is calculated by dividing net profits by net sales – or – net income by revenue during a set period of time. When someone asks, “What is your company’s profit margin?” this is usually the metric that they’re looking for. This is considered to be one of the best ways to judge the overall financial health of an organization. It’s an indicator of how well profit is being generated and costs are being contained. For this reason, Net Profit Margin is what investors will want to know because it helps them to assess whether a company is a good investment. Example: Sales $100,000 minus Variable CoGS $30,000 minus Fixed CoGS $15,000 minus Operating Expenses $30,000 minus Net Interest Cost $20,000 minus Taxes $1,000=$4,000 or 4%.
The best way to analyze margins is by comparing over a period of time to spot anomalies in the specific margins and investigate the reason(s) for these variations. Also, comparing like margins to industry standards or competitors helps provide insight as to how the business is performing in comparison to their peers.
It’s important to note that profit margins vary according to the type of industry. It’s not as simple as comparing apples to apples. What is a good net profit in food manufacturing or transportation, for example, could be considered below average in entertainment or retail luxury fashion.
When looking at profit margins, there are other factors at play. A bakery that doesn’t have a high profit margin could have consistently high sales in large quantities. Conversely, a luxury real estate agent might not make many sales per year, but those properties sold will have high sales commissions. Pharmaceutical and technology companies may spend huge amounts in research and development, patents and licensing, but then reap huge sales profits on a per-unit basis.
Sometimes there are fixed or variable costs that will affect profits. For example, transportation companies have to pay fuel costs (which can jump unexpectedly), vehicle maintenance fees, and offer competitive wages and benefits to retain good drivers.
Costs for raw materials can fluctuate wildly, depending on market conditions. For example, a food manufacturing company that makes gourmet cakes might find ingredients like vanilla or flour costs increase drastically due to worldwide shortages or supply chain issues. All of these things will affect the bottom line.
A common misconception is that Margins and Markup are the same thing, when in fact they are not and produce different results. A margin is sales less costs divided by sales (example: Sales of $100 minus costs of $70=$30 or 30%) whereas markup is cost times a percentage to get a selling price (example: an item costs $70 and the markup is 30%, this equals sales of $91. Sales $91 minus cost $70=$21 or 23.07% margin). It is really important to understand the difference between markup and margin when setting prices for products. Margin calculations provide consistent contribution margins whereas markups provide variable contributions margins that are less than the markup value.
It’s important to have financial professionals who can help you to understand the metrics for your business. If you have a small- or medium-sized business, this is one of the benefits of hiring a Virtual CFO.
We invite you to contact Finatics Accounting Solutions so we can discuss how our Virtual Accounting Team can help you achieve your business goals.