Related Terms: Financial Ratios
The profit margin is an accounting measure designed to gauge the financial health of a business or industry. In general, it is defined as the ratio of profits earned to total sales receipts (or costs) over some defined period. The profit margin is a measure of the amount of profit accruing to a firm from the sale of a product or service. It also provides an indication of efficiency in that it captures the amount of surplus generated per unit of the product or service sold. In order to generate a sizeable profit margin, a company must operate efficiently enough to recover not only the costs of the product or service sold, operating expenses, and the costs of debt, but also to provide compensation for its owners in exchange for their acceptance of risk.
As an example of a profit margin calculation, suppose firm A made a profit of $10 on the sale of a $100 television set. Dividing the dollar amount of earnings by the product cost, that firm's profit margin would be .10 or 10 percent, meaning that each dollar of sales generated an average of ten cents of profit. Thus, the profit margin is very important as a measure of the competitive success of a business, because it captures the firm's unit costs.
A low-cost producer in an industry would generally have a higher profit margin. Since firms tend to sell the same product at roughly the same price (adjusted for quality differences), lower costs would be reflected in a higher profit margin. Lower cost firms also have a strategic advantage in a competitive price war: they have the ability to undercut their competitors by cutting prices in order to gain market share and potentially drive higher cost firms out of business.
Firms clearly exist to expand their profits. But while increasing the absolute amount of dollar profit is desirable, it has minimal significance unless it is related to its source. This is why firms use measures such as profit margin and profit rate. Profit margin measures the flow of profits over some period compared with the costs, or sales, incurred over the same period. Thus, one could compute the profit margin on costs (profits divided by costs) or the profit margin on sales (profit margin divided by sales).
Other specific profit margin measures often calculated by businesses include: 1) gross profit margin—gross profit divided by net sales, where gross profit is the total money left over after sales and net sales is total revenues; and 2) net profit margin—net profit divided by net sales, where net profit (or net income) is profit after deducting costs such as advertising, marketing, interest payments, rental payments, and taxes. This last ratio, the most common, has hovered around 5 percent overall in all business activities.
Profit margin is related to other measures such as the rate of profit (sometimes called the rate of return), which comprises various measures of the amount of profit earned relative to the total amount of capital invested (or the stock of capital) required to generate that profit. Thus, while the profit margin measures the amount of profit per unit of sales, the rate of profit on total assets indicates the efficiency of the total investment. Or, put another way, while the profit margin measures the amount of profit per unit of capital (labor, working capital, and depreciation of plant and equipment) consumed over a particular period, the profit rate measures the amount of profit per unit of capital advanced (the entire stock of capital required for the production of the good).
Using our previous example, if a $1,000 investment in plant and equipment were required to produce the $100 television set, then a profit margin of 10 percent would translate into a profit rate on total investment of only 1 percent. Thus, in this scenario, firm A's unit costs are low enough to generate a 10 percent profit margin on the capital consumed (assuming some market price) to produce the TV set; but in order to achieve that margin, a total capital expenditure of $1,000 must be made.
The difference between the profit margin measure and the profit rate concept then lies in the rate at which the capital stock depreciates, and the rate at which the production process repeats itself, or turnover time. In the first case, if the entire capital stock for a particular firm or industry is completely used up during one production cycle, then the profit margin would be exactly the same as the profit rate. In the case of turnover, if a firm succeeds in doubling the amount of times the production process repeats itself in the same period, then twice as much profit would be made on the same capital invested, even though the profit margin might not change. More formally, the rate of return = profit margin × sales / average assets, where average assets is the total capital stock divided by the number of times the production process turns over. Thus, the rate of return can be increased by increasing the profit margin or by shortening the production cycle. Of course, this will largely depend on the conditions of production in particular industries or firms.
If costs rise and sale prices do not rise to keep up, then the profit margin will fall. In times of business cycle upturns, prices tend to rise; in business cycle downturns, prices tend to fall. Of course, many factors, and not only costs, will affect the profit margin—namely, industry-specific factors that relate to investment requirements, pricing, type of market, and conditions of production (including production turnover time).
It is important for small business owners to remember that generating a profit margin does not guarantee that their business is healthy, or that they will have money in the bank. Rather, a small business must have a positive cash flow in order to pay its bills and compensate its employees. To use a profit margin figure to determine whether a start-up firm is doing well, an entrepreneur might compare it to the return that would be available from a bank or another low-risk investment opportunity.
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The Ultimate Small Business Guide: A Resource for Startups and Growing Businesses. Basic Books, 2004.