Profit margin is an important indicator for measuring company profitability. By knowing this, you can monitor your financial condition and assess the growth of your business.
On the other hand, ignoring this indicator has the potential to fail you to find the location of the “cost leak” thereby causing greater losses.
If you don’t want that to happen, let’s look at the definition, benefits, types and ways to increase profit margins in this article!
What is Profit Margin?
Quoting Investopedia, profit margin is a metric to measure the extent to which a company or business activity generates profits.
Usually profit margin is expressed in percentage or decimal to express how much sales revenue can be used as profit.
Regarding the criteria for a good profit margin, it depends on the company and industry. The reason is, each industry has a profit margin that varies and differs from one sector to another.
Therefore, to compare the financial performance of a company, you have to do it apples to apples.
Never compare retail company profit margins with oil and gas company profit margins. So far you understand, right?
Benefits of Knowing Profit Margin
Profit margin is a measure of how efficiently a company makes money. That way, there are many benefits that can be obtained by having a good understanding of profit margins. Here are some of them.
1. Evaluate Business Profits
Profit margin informs how much the company’s profit level is from sales. By understanding it, companies can assess whether the business they run generates adequate profits or not.
Apart from that, companies can also observe financial performance over certain time periods so that it can be used as evaluation material for decision making in subsequent periods.
For companies that operate several geographically dispersed business divisions, profit margin can be used to assess the performance of each unit and compare them with each other.
2. Industry Comparison
Global market conditions may fluctuate and have a significant impact on the business world. However, with profit margin, you can assess how your financial performance is amidst current market conditions.
The method is to compare the company’s profit margin with other companies from the same industrial sector. Is the profit margin value still within the average value, below, or above the industry profit margin?
This provides an understanding of whether the company has better or worse financial performance than competitors.
3. Identify the Problem
Profit margin can also be used to identify operational problems. This includes studying expenditure items that have a negative impact on cost efficiency. By knowing this, of course companies can take appropriate steps to overcome this.
Furthermore, profit margin also helps companies study seasonal patterns and company performance over different time periods so that all business processes become better monitored.
4. Track Financial Performance
Regularly monitoring profit margins allows companies to track financial performance over time. This greatly helps the company in identifying profit trends and allows the company to take corrective action if its profit margin continues to decline.
5. Attract Investors
Profit margin is one of the highlighted points in financial reports because it can greatly influence investment decisions. Companies with higher profit margins will be more attractive for investors to invest their funds.
Types and How to Calculate Profit Margin
The following are the types and methods of calculating profit margin that you must understand:
1. Gross Profit Margin
Gross profit or gross profit is the remaining income after deducting the cost of goods sold (COGS). Where COGS are the costs required to produce products or services, such as raw material costs, labor wages, and factory overhead costs.
To calculate it, you can use the following formula:
Gross profit = revenue – cost of goods sold
Meanwhile, gross profit margin is a metric in percentage or decimal form to express the gross margin ratio of the income received. Here’s the formula:
Gross profit margin = (gross profit : revenue) x 100%
A high gross profit margin shows that the company has a competitive advantage in managing production costs. Meanwhile, a low gross profit margin indicates that the company needs to improve and streamline its operational activities.
2. Operating Profit Margin
Operating profit or operational profit is the remaining income after deducting the cost of goods sold (COGS) and operational costs. In this case, operational costs are costs incurred to keep the business running, for example equipment rental costs, employee salaries, marketing costs and inventory.
To calculate it, you can use the following formula:
Operating profit = revenue – cost of goods sold – operating costs
Meanwhile, operating profit margin is a metric to express the ratio of operational profit to revenue received. Here’s the formula:
Operating profit margin = (operating profit : revenue) x 100%
The higher the operating profit margin, the more efficiently the company manages operational costs and generates profits from its operating income.
3. Net Profit Margin
Net profit or net profit is the remaining income after deducting COGS, operational costs, interest and taxes. To calculate it, you can use the following formula:
Net profit = revenue – COGS – operational costs – interest – taxes
Meanwhile, net profit margin is a metric to express the ratio of net profit to revenue received. Here’s the formula:
Net profit margin = (net profit : revenue) x 100%
Compared to the other two types, net profit margin is the most complete indicator of profitability because it takes into account direct and indirect costs.
The higher the number, the more effective the company is in managing costs and generating net profits from the revenue earned.
How to Increase Profit Margin
After understanding the types and how to calculate them, you can find several ways to increase the company’s profit margin. Here are some of them:
- Simplifying company processes and operations by increasing efficiency and productivity of existing resources.
- Cut operational costs and expenses that are considered ineffective so that you can increase profit margins without disrupting business processes.
- Identify products/services that have the potential to provide the largest profit margin so that you can prioritize them to get maximum profits.
- Adjust the selling price of the product by increasing it so that the level of profit obtained can be greater. But to do this, you need a neat strategy, OK?
- Maintain and build existing customer loyalty. The reason is, it costs five times more to get new customers than selling to existing customers.
That is information about profit margin and its role in business. Talking about business is not far from financial problems. Therefore, you must document every transaction and business administration process with Labamu features so that it is easy to identify if there are leaks in expenses.
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