Profit margins

 

This page discusses the primary types of profit margin. For margin borrowing see the article on margin.

There are three common profit margins:

Gross Margin

Gross margin represents the percent of each dollar spent towards generating sales that a company earns as profit. Gross margin is calculated by subtracting Cost of Goods Sold (COGS) from Net Sales (yielding Gross Profit), which is then divided by Net Sales. That is,

Gross Margin = (Net Sales - Cost of Goods Sold) ÷ Net Sales.

COGS can include direct labor costs, productions, and other per unit (or variable) costs - these are typically costs that can be directly tied to sales generated or split revenue.


Uses: On its own Gross Margin is not very useful, but it can be used for intra-industry analysis. For example, one may compare Google's pricing power against that of Yahoo! or Microsoft, but because most competitors have diversified business (i.e. other sources of revenue), the valuation insight provided may be diminished.

Operating Margin

Operating margin is the proportion of revenues remaining after paying the costs of operating the business, such as labor costs (wages), raw materials, overhead, depreciation and amortization, selling, general, and administrative expenses, advertising, etc. Operating margin can be calculated by dividing Operating Profit by Net Sales. That is,

Operating Margin = Operating Profit ÷ Net Sales.


Uses: Operating Margins are useful in intra-industry comparisons of companies with different debt structures. Because interest expense is not included in determining Operating Profit, debt is controlled for across companies. Operating Margins really demonstrate the operating efficiencies of the business

Net Profit Margin

Net profit margin represents the percent of total revenue that a company keeps as profit after accounting for all other costs, variable and fixed. It can be calculated by dividing Net Income by Net Sales. That is,

Net Profit Margin = Net Income ÷ Net Sales.


Uses: Net profit margin can be used to compare the profitability of companies within the same industry and to compare a company's profitability to it's past performance. Net profit margin, unlike gross profit margin and operating profit margin, measures the profitability of a company's entire enterprise, including its capital structure. If two similar companies are facing rising costs and/or increased competition (therefore, lower prices), but one company has more debt than the other, the analyst may see significantly different profit margins between the corporations.

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