Profit margin is a financial ratio used to evaluate a company’s profitability. A high profit margin means that a high percentage of revenue is actual profit. Companies must reduce costs, evaluate products, and fend off competition to create a high profit margin. Pricing strategy contributes significantly to a high profit margin. Another ratio used to evaluate productivity is gross profit margin.
A profit margin, also called net income margin, is a financial ratio used to evaluate a company’s profitability. When a company has a high profit margin, it means that a high percentage of every dollar the company generates in revenue is actual profit. For example, a 19 percent profit margin means that 19 cents of every dollar in revenue is a profit for the company. In order to create a high profit margin, companies must actively reduce costs, strategically evaluate their products and services, and fend off the competition. The percentage that constitutes a high profit margin varies across industries and industries, limiting the use of the profit margin to internal comparison or comparison between companies in the same industry.
Accountants and corporate executives calculate profit margin using financial information for a limited period. First, costs of sales, operating costs, and overheads are subtracted from total revenue. Secondly, any interest charges and repayments are deducted. The resulting value is the net profit. An accountant can then derive profit margin by dividing net income by total revenue and multiplying that value by 100 to get a percentage.
A company’s pricing strategy can contribute significantly to a high profit margin. In choosing the right price for a product or service, the company must first set a price high enough to recoup all costs. A price, however, should not be set so high that it excludes customers. Other pricing considerations include product demand, product quality, advertising and promotional plans for the product, and product distribution. The limits of a well-determined price are the price, where the company makes a loss by selling the product, and the price ceiling, where customers refuse to buy the product.
Another ratio used to evaluate the productivity of the company is the gross profit margin. The top number in this ratio is gross profit, defined as total revenue minus costs of goods sold. Like the profit margin, the bottom of the ratio is the total amount of revenue. Because gross profit margin is expected to remain relatively stable over time, substantial fluctuations are signs of possible accounting misstatements or fraudulent activity. When obtained using gross margin calculations, a high profit margin indicates an organization that should be able to generate reasonable net income, with cash left over for dividends, provided the company controls its costs.
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