What is the Profit Margin & How to Calculate?

Companies can calculate their financial data on time to keep their cash flow positive. Calculating a profit margin is one of the most basic and straightforward ways to understand – it shows how much profit a company makes from the products they sell.

A positive cash flow assists the company in making a positive impression on customers. The profit margin ratio can also provide information about the company’s revenue.

What is the Profit Margin? 

Every company enters the market to achieve its objectives and profit from the sale of goods.

Companies needed raw materials to develop products. They purchase their required materials as per their need. This is an investment, and every business owner is invested in products if they are concerned about the return on investment.

Organizations also consider production costs when determining product prices. Companies add their profit margin rate after adding the production costs and then deliver the products to the market with the final price.

Organizations must minimize all of their production costs when calculating their revenues. Which amount the organization receives after deducting the production cost and other costs – this amount is the net revenue for the organization.

For reaching a net income of an organization use the net profit margin ratio formula. This profit margin ratio helps the organization in gaining investors’ or financiers’ trust. This margin ratio gets positive vibes when they analyze that an organization has the skill to convert their investment into income from selling the products in the competitive market.

One of the most important reasons for businesses to focus on keeping a sustainable profit margin. Every company has its own goal and as per their goal, they decide their net profit ratio.

Also Read: 7 PROVEN WAYS TO INCREASE THE PROFIT MARGIN FOR YOUR BUSINESS

How to calculate the profit margin ratio?

Accountants must follow a few steps to calculate the profit margin!

Step 1: Calculate the net sales

Organizations must use the following formula to calculate net sales to calculate the margin ratio.

Net Sales = revenue - return, refund, and discounted products rates

In the first stage, the organization calculates net sales by subtracting revenue from returns, refunds, and discounted materials.

Step 2: Calculate the net income

In the second step, the company must determine its net income using the below formula.

Net Income = revenue - total expenses

Organizations spend money on product development and promotion to increase awareness about their products. As a result, they must deduct all expenses from their revenue(total selling) when determining the profit margin.

Step 3: Calculate profit margin ratio

The profit margin ratio is calculated using the below formula in the third step.

Profit Margin = (net income / net sales) x 100

Businesses find the values in % when calculating the ratio. If their profit margin ratio is larger than their competitors, they are profitable; otherwise, they must enhance their methods to boost their profit margin ratio.

Type of profit margins and how to calculate?

The profit margin can be calculated in three ways: gross profit margin, operating profit margin, and net profit margin.

Gross Profit Margin

The easiest formula for computing a ratio is the gross profit margin. Throughout this calculation, businesses got the amount that is remaining after accounting COGS(Cost Of Goods Sold).

The cost of goods sold (COGS) covers all production costs as well as the salary of the laborers who are needed to make the goods. This figure excludes taxes, debt, fixed costs, overhead costs, and one-time expenses. Variable costs, on the other hand, occur throughout a process and change with the rate of production or production.

If an organization is not involved in the manufacturing process, the cost of revenues, or the amount required to sell the products, can be used.

Here is the formula for calculating the Gross profit margin…

Gross Profit Margin= (Net Sales - Cost Of Good Sold(COGS) / Net Sales ) x 100

Operating Profit Margin

The gross profit margin ratio is more difficult to calculate than the operating profit margin ratio. Day-to-day business expenses are calculated as well as the company’s assessment when computing an operating profit margin. However, non-operating costs such as loans and taxes are not included in the operating profit margin formula.

Accountants divide operational revenues by organizational revenues in this calculation. As a result, the organization receives the ratio of the remaining amount after all expenses have been paid.

Businesses can determine the operating profit margin using the below formula.

Operating Income = revenues + COGS - administrative and selling expenses 

Operating Profit margin = Operating Income / revenue x 100

Net profit margin

Organizations achieve accurate results when they use the net profit margin formula to calculate the profit margin ratio. The COGS, tax debts, and one-time expenses or payments can all be deducted using this formula. The ability of a company to turn revenue into profit is measured by its net profit margin.

Follow the below formula to calculate the net profit margin…

Net Income = (Revenue - (COGS + Operating Expenses + Other Expenses + Tax + Interest)

Net profit margin = (Net Income / Revenue) x 100

Which formula is most useful? 

Net profit margin is the most widely used formula. Because an organization’s net profit margin allows them to reduce revenues from their net income and obtain an appropriate net income.

The amount of taxes and debts is never minimized by the operating margin or gross margin. Organizations, on the other hand, can deduct the amount of taxes and debts from their revenue when determining net margin. As a result, the final amount represents the net profit earned by the companies.

This is one of the reasons why businesses may deduct their revenues from their sales and get an exact result.

For example,

ABC is one of the most well-known fabric manufacturers on the market. Their net sale at the end of the month is Rs. 1,00,000, with a net income of Rs. 10,000.

The profit margin is now calculated by ABC’s accountant using the net profit margin formula:

Net Profit Margin  = (Net Income / net sales) x 100

                   = (10,000 / 1,00,000) x 100


                   = 10%

As a result of the computation, investors or financiers can determine that ABC companies can offer products with a 10% margin.

Conclusion

Every corporation needs a profit margin. And a larger margin ratio indicates that the company is skillful. As a result, businesses are focussing on boosting revenues while lowering costs.

Accounting software may now be used by businesses to calculate profit margins. The accountant’s task becomes easier when they use the software, and they can calculate the correct amount. Also, organizations can store their day-to-day transactions in software, there are fewer chances of making a profit margin calculation error.

Contact us to get the best accounting solution for your organization.

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