What is Profit Margin?

Calculating profit margin is like taking a snapshot of a company...

It’s a single number representing how well the company is doing considering both what it makes and what it spends. If one company takes in $2M a year and another $1M, but the first company’s expenses are much higher than the second, then its profit, and therefore its profit margin, should be lower.

Let’s go back to that lemonade stand you set up in your parents’ driveway as a kid. You may have been doing it for fun, but maybe your neighbor jokingly asked if he should invest in your business. You could easily have told him whether it was a good investment by calculating your profit margin. You’d start with all the money you’d earned selling lemonade, then subtract the money you spent on ingredients and supplies: lemons, sugar, water, cups, a table and chairs, and even the crayons you used to make a sign. Then you’d divide the result by all the money you earned. If you made $100 by selling 100 cups of lemonade at $1 per cup, and all your ingredients and supplies cost you $40, then your net profit margin is 60% ($100-$40 = $60, and 60/100 = .60 or 60%). Your neighbor would be impressed!

You may assume that a good profit margin is a very high number, but even the most successful companies aren’t as lucky as that lemonade stand. Most companies don’t clock in much more than 20%. That’s because operating expenses are so high for many businesses. These include things like taxes, employee compensation, fancy offices, and stores that will attract customers. Generally, a 10% net profit margin is considered okay, and anything below that could use improvement. Meanwhile, 20% is considered quite good, and anything higher is great.

While net profit margin is the big one – the number that puts a stamp on the company that says “you’re doing well” or “you could do better” and the one most people think of when they hear the term “bottom line,” there are other types of profit margins that companies use to calculate how well they are doing or how well a specific product or service is doing. These can be just as important for investors evaluating a company, whether they’re Silicon Valley titans offering early seed money or stockholders looking to buy and sell.

Gross profit margin is a way of zeroing in on a specific product and figuring out how successful it’s been for the company. This number takes into account not only the price of the product, but also the “cost of goods sold,” or the direct cost of making the product. Going back to the Apple example, this would be the cost of creating a specific iPhone – materials, labor, and software development – subtracted from the amount of money Apple makes from selling that iPhone, then divided by that revenue and multiplied by 100.

Operating profit margin is more helpful to a company — or to bankers or analysts considering it for a buyout — than it is to the average consumer or investors. It represents the amount of money left over once the company subtracts operating expenses, but before it pays interest and taxes. This number gives company leaders a solid picture of where the company stands and what it can afford in the future.

To calculate each type of profit margin, you have to plug slightly different numbers into a fairly straightforward equation. Most of the time, you can obtain these numbers from a company’s income statement, which is a financial document highlighting a company’s profit over a set period of time.

As in both the Apple and lemonade stand examples above, this equation is roughly:

Profit/Revenue = Profit Margin x 100 = Profit Margin Ratio

Profit is the money a company generates, minus its expenses, whereas revenue is the money the company generates, period. If a company spends more than it generates, that top number (profit) will be negative, making the profit margin ratio negative as well.

You can find easy-to-use profit margin calculators online.

To achieve a high profit margin, your company has to sell goods for more money than it takes to produce them. Unsurprisingly, luxury goods industries like fashion, fine watchmakers or jewelers, or software companies, often have high profit margins. It doesn’t hurt that their products can sit in the store for as long as it takes to sell them — They never have to throw anything out, because nothing goes bad.

Low profit margin industries are often those that sell perishable items that cannot sit on shelves for more than a few days, like grocery stores or specialty food shops. Airlines also have very high overhead (fuel, airport fees, the sheer cost of making and maintaining an aircraft) and consequently, lower profit margins.