Tara received her MBA from Adams State University and is currently working on her DBA from California Southern University. She spent 11 years as a sales and marketing executive. She spent several years with Western Governor's University as a faculty member. Tara has been at Study.com for seven years.
What is Profit Margin?
Profit margin is an important calculation in business. It indicates whether or not the pricing strategies of the company are working and if the company is adequately controlling costs. By comparing the profit margin of one company to another similar company, the managers can see how their profitability relates to the competition, as well as how their cost-efficiency compares to other companies.
For illustration, a small, regional shoe company sells $5,000 in shoes and has $3,000 left over after Cost of Goods Sold (COGS - the expenses specifically tied to creating those shoes) is subtracted. The company's net profit margin is 60%, meaning they keep 60% of the money the business makes from selling those shoes. If the percentage is higher, the company is making more money off of their sales. For instance, if they sell $5,000 and have $4000 left over after COGS, their net profit margin goes up to 80%. The higher the net profit margin percentage, the more money the company is keeping.
If the Nexis Shoe Company has a net profit margin of 60% and finds out their competitors have a net profit margin of 40%, Nexis' is more profitable than their competition because their profit margin is 20% higher than their competitor's.
How is Profit Margin Calculated?
Profit margin is based on two key factors: Total Sales, Cost of Goods Sold. The formula for figuring profit margin is:
Profit Margin = COGS / Sales * 100
Returning to our earlier example, we would figure profit margin like this:
COGS = $3000
Sales = $5000
Profit Margin = $3000 / $5000 * 100
Profit Margin = .6 * 100
Profit Margin = 60%
By utilizing profit margins, companies can understand how well they are maximizing sales, controlling expenses, and comparing to their competition. Appropriate profit margins will vary by industry and types of product manufactured; therefore, it is important that a company understand what a standard profit margin is for their industry. Understanding what the typical profit margin is allows a company to further evaluate how well they are doing based on the comparison of the company's profit margin to the industry's standard profit margin.
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