Margin is the difference between the cost associated with development or sales and the cost at which it gets sold. However, companies use various types of margins in the business. In the stock market, a margin is the initial token amount. Whereas, in trading, the margin is the deposit to stand in the market. So, calculating the margins helps to understand how the company or product will survive in the changing market demands. Let us know about ‘How To Calculate Margin?’.
The study shows that the USA focuses on the Net, Operating, and Gross Profit margins. They require the company’s revenue, COGS, and other metrics. The Net Profit Margin is the easiest one to get calculated.
Profit Margin
It helps recognize the profit made by the company depending on the revenue. It has three categories: Gross, Net, and Operating Profit Margin which focus on different aspects and have varying requirements. They come with the ideal ratio and limitations.
1. Gross Profit Margin
It is the amount left after paying for the production, labor, and material costs. This margin depicts the sales percentage in most cases and can get easily calculated. Higher Gross Profit Margin indicates that more revenue is left to cover other costs like tax, debt, etc. It gets expressed in percentage (%).
People often get confused between the Gross Margin and Gross Profit Margin. The former shows the latter in the percentage of sales. The latter shows the difference between the direct selling costs and the company’s sales.
The Gross Profit Margin shows how efficient the company’s operations are. It is a straightforward method to calculate the profit of the company. Thus, people investing in stocks must consider it.
Calculating Gross Profit Margin
The metrics required to calculate the Gross Profit Margin are:
Revenue and Cost Of Goods Sold (COGS). One can calculate Revenue by multiplying the average price of sales per unit by the number of units sold. Talking about the COGS, it gets calculated by adding the additional costs to the initial inventory cost.
| Gross Profit Margin = ((Revenue – COGS) / Revenue ) * 100 |
Example Of Calculating Gross Profit Margin
Revenue = $100,000 and COGS = $35,000
Gross Profit Margin = (($100,000 – $35,000) / $100,000) * 100
= ($65,000 / $100,000) *100
= $65,000
Ideal Gross Profit Margin
The ideal Gross Profit Margin is 30 to 50%. It differs according to the operations of the company. The following are the ideal Gross Profit Margins for various sectors:
- Retail = 3% to 13%
- Legal firms, service sectors, and financial organizations = more than 50%
- Fast food chains = up to 40%
- IT sector, banks, and law firms = 90%
Limitations Of Gross Profit Margin
It is relative. The Gross Profit Margin of one sector (for instance, retailer) cannot be compared to that of the other (heavy machines equipment). On the one hand, IT industries have lower costs of goods and higher Gross Profit Margins.
On the other hand, manufacturing and mining industries have higher goods costs and lower Gross Profit Margins. A fluctuation in this ratio indicates poor products and management practices. However, the fluctuation can get justified temporarily.
2. Net Profit Margin
It is the profit generated from the sales revenue. It gets expressed in percentage (%) and decimal form (.). Thus, it gets easier to compare the Net Profit Margins of two or more businesses differing in size.
Calculating Net Profit Margin
The metrics required to calculate Net Profit Margin are Taxes (T), Revenue, Cost Of Goods Sold (COGS), Interest (I), and Other Expenses (E).
| Net Profit Margin = ((Revenue – COGS – I – E – T) / Revenue) * 100= (Net Income / Revenue) * 100 |
Example Of Calculating Net Profit Margin
Revenue = $225,000, COGS = $35,000, I = $10,000, E = $40,000, and Tax = $60,000
Net Profit Margin = (($225,000 – $35,000 – $10,000 – $40,000 – $60,000) / $225,000) *100
= ($80 / $225,000) * 100
= 35%
Ideal Net Profit Margin
The ideal Net Profit Margin can be 5%, 10%, and 20% representing poor, average, and good respectively. However, it depends on the industry.
Limitations Of Net Profit Margin
It is said that the Net Profit Margin of two or more companies can get compared. But, this ratio differs across industries. For instance, a lower Net Profit Margin (and higher revenue) is acceptable for the food industry. But, the automotive industry and jewelry stores must have a higher Net Profit Margin.
Lower Net Profit Margin does not indicate poor cash flow, and a higher ratio does not indicate high cash flow. Companies with debt and additional expenses have lower Net Profit Margins. A temporary increase in this ratio does not indicate long-term success.
3. Operating Profit Margin
The name suggests that the Operating Profit Margin is the amount earned by the company after paying for operational costs such as wages, production, etc. It gets calculated before paying tax or interest. Looking at the past Operating Profit Margins is better to determine the company’s performance. A higher difference in the ratio shows business risk.
Calculating Operating Profit Margin
The metrics required for calculating the Operating Profit Margin are Revenue and Operating Income. The definition of this profit margin explains how to calculate the Operating Margin.
| Operating Profit Margin = (Operating Margin / Revenue) * 100= ((Revenue – COGS – E) / Revenue)*100 |
Example Of Operating Profit Margin
Revenue = $10M, COGS = $5M, E = $2M
Operating Profit Margin = (($10M – $5M – $2M) / $10M) *100
= ($3M / $10M) *100
= 30%
Ideal Operating Profit Margin
Gaming and software companies from the service sector have lower production costs due to fewer assets. They have a higher Operating Profit Margin. On the other hand, automobiles, luxury goods, transportation, high-end accessories, agriculture ventures, etc have lower Operating Profit margins due to the operational expenses.
Limitations Of Operating Profit Margin
One cannot determine the income tax expenses, cash flow, business restructuring, or company’s growth rate. Only companies with a similar business model and annual sales can use this ratio for comparison.
Conclusion
Some countries may introduce several metrics to calculate various margins. However, research shows that the US focuses on the three primary margins Net, Operating, and Gross Profit Margins. They help understand the position of the company in the market and the measure for the growth of the company.
