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Your Guide to Profit Margins

Your Guide to Profit Margins

Profit margins are not as simple as they look. Read this article to discover the hidden complexities within them and how they can help your business.

2nd September 2019
Reading Time: 2 minutes

There are many hidden complexities to profit margins. This article plans to alleviate any confusion by emphasising both Net and Gross profit margins. We’ll also explain how using these the right way will benefit your business.

What is a Margin?

This determines your business’s surplus and can help you make budgeting and pricing decisions. Determining your margin will assist you in all aspects of the business, particularly in the finance and accounting areas. The formula to calculate your margin is:

Margin = (sales – cost of goods sold) / sales x 100

Net and Gross Profit Margins

Net Profit Margin (NPM)

A NPM ratio shows the proportion of cash gained for each sales dollar after expenses. An acceptable NPM ratio varies from industry to industry, but generally, the higher the better. This is a good tool that reveals the amount of disposable cash that a business can extract from its total sales. The relevant formula which applies is:

NPM = net profit / sales : 1.0

Gross Profit Margin (GPM)

A GPM ratio shows the proportion of cash gained for each sales dollar before expenses. An acceptable GPM ratio varies from industry to industry, but in general, the higher the better for your business. This is primarily used to assess the company’s financial health by revealing the amount of money left over from sales after deducting the cost of goods sold (COGS). The relevant formula is:

GPM = gross profit / sales : 1.0

Net Vs Gross

The difference between your NPM and GPM is important and vastly differs. These results will be shown on your profit/loss statements. The GPM is your sales minus your COGS, which does not include your business operating expenses. The NPM is a more reliable and truer indication of profit which includes both the COGS and operating expenses, displaying the the most accurate form of cash gained.

Example

Imagine firm X made a profit of $10 on the sale of an $100 radio. By dividing the dollar amount of cash gained by the product cost price (10/100), you can ascertain that there is a 10 percent profit. This also means that each dollar of sales would mean ten cents of cash gained. This demonstrates that although a profit margin is simply an accounting tool, it is an extremely important mechanism that measures the competitive success of a business by capturing the firm’s unit costs.

Conclusion

There is no such thing as a simple ‘Profit margin’. While it may seem basic and easy to understand from face value, margins can be quite in-depth. Once you have ascertained the difference between net and gross profits, it is always recommended that you use the NPM as your reliable source. This will be your true indication of the cash gained and will allow you to make appropriate and more reliable business decisions. If you want further advice on using profit margins, it is worth speaking to a business lawyer.

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Author
Alex Vella

Alex works in the content team as a Legal Intern for Lawpath. He is studying a Bachelor of Commerce (Professional Accounting) and Bachelor of Laws at Macquarie University. His passion resides with commercial, corporate and tax law.