Different types of profit require different methods of calculation for profit margin. Gross profit is a more reliable indicator of profitability, while net profit includes external factors. EBITDA is a popular measure of profitability. Investors use these measures to determine a firm’s profitability accurately.
There are different types of profit and therefore there are different ways to calculate the profit margin. Profit is generally understood to be a firm’s revenue minus all costs and expenses of earning that revenue, but in determining a firm’s efficiency, other understandings of profit are significant. Two of the more commonly known forms of profit are gross profit and net profit. Gross profit is revenue from sales minus cost of goods sold (COGS); net profit is gross profit minus overhead items such as rent and taxes.
Gross profit is often a more reliable indicator of a firm’s profitability, as it primarily involves cost items over which the firm has great control, especially the costs, including labor, of converting raw materials in the state into which they are sold. Net income is a less reliable indicator of a firm’s actual profitability because it reflects many factors generally outside the firm’s control, such as rentals and costs associated with distribution.
An easy way to calculate profit margin based on gross profits is to first calculate gross profit by determining the COGS and subtracting it from total revenue. The result is gross profit. Gross profit margin is the ratio of gross profit divided by total revenue. For example, if a business has total annual revenue of $1,000,000 US dollars (USD), with COGS of $750,000 USD, gross profit is $250,000 USD, and gross profit margin is 25 percent ($250,000 / $1,000,000).
To calculate your profit margin based on net profits or net profit margin, you need to take into account all other costs associated with the business. Therefore, using the example above, if rent, taxes, utilities, and all other expenses total $110,000 USD, your net income for the year is $140,000 USD. To calculate profit margin based on net income, divide net income by total sales ($140,000 / $1,000,000), for a result of 14 percent.
There are other profitability measures, each of which require profit margin calculations to be calculated slightly differently. For example, earnings before interest, taxes, depreciation, amortization (EBITDA) is a particular method of calculating the profit margin by excluding all costs not incurred by the actual operation of the enterprise. EBITDA became a popular measure of profitability in the last two decades of the 20th century because it was essentially a way of calculating profit margin on a cash basis, without the inclusion of accounting accruals outside the immediate control of the business.
These various measures of profitability are important to investors because they are considered better indicators of a firm’s profitability than net profit margins, which include costs not directly related to the firm’s operations. For example, if two competing firms have identical net profit margins, but one is paying taxes at a higher rate than the other, the tax payments distort the firms’ actual profitability. Removing the tax payments from the profit margin calculation will reveal that the company that paid the higher tax rate was actually more profitable.
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