What is Profit margin? Classification and detailed calculation of Profit margin

What is profit margin? How important is this indicator in the development of a business? There are different types of profit margins and how are they calculated? All will be answered in the content of Viindoo.

What is Profit margin?

Profit Margin is an indicator that shows the difference between a business's revenue and profit. Specifically:

• Revenue: This is an indicator showing the development scale, the ability to dominate the market of the enterprise. Revenue is directly proportional to the market share of the business, the higher the revenue, the larger the market share of the business.
• Profit: Profit is a part of the business's revenue, This is a financial source for enterprises to expand production scale and reinvest in the next quarter/year. 

Profit Margin is often used as a comparison measure between businesses because this index represents the potential and assesses the financial health of businesses in the same field. The higher this index, the more profitable the business is, and the better the control and management of capital and production and operating costs. 

Example: The profit margin of a business in the third quarter of 2021 is 20%. This index shows that for 10 dollars of revenue, the business will earn 2 dollars of profit.

Profit margin

Classification and calculation of profit margin

Profit margin is divided into three categories: gross profit margin, operating profit margin and net profit margin. Each of these types will have different calculation methods, which are detailed below:

Gross profit margin 

Gross profit margin is an indicator that reflects the profit business earns from selling expenses of cost of goods sold. The efficiency of using labor and materials in the production and business process of the enterprise can be seen through the gross profit margin.

Formula to calculate gross profit margin:

Gross profit margin = (Revenue - Cost of goods sold) / Revenue

Example: Company X's revenue is 900 million VND. Cost of goods sold, including the cost of buying raw materials and labor costs, is VND 300 million.

Gross profit margin = (900,000,000 – 300,000,000) / 900,000,000 VND ≈ 66.67%

A company has excess cash when it has a high gross profit margin. The company can use this surplus money for different purposes to develop the business such as business expansion, reinvestment, and product development, etc. If the cost of goods sold increases, the gross profit margin will decrease, Therefore, enterprises need to have reasonable spending policies to keep the gross profit margin at a stable level.

The higher the gross profit margin is, the larger the balance of the business is.

>>>> Reference: What is ROE?What is ROA? Calculation and meaning of ROE in finance

Operating profit margin

Operating profit margin is the comparison of earnings before interest and taxes with sales. This index can help businesses self-assess the level of effectiveness in managing revenue from production and business activities. 

The formula for calculating operating profit margin:

Operating profit margin = Profit before tax (EBIT) / Sales

Example: A business has a profit before tax of VND 500 million and sales of VND 800 million. Operating profit margin = 500,000,000 / 800,000,000 = 62.5%

Operating profit margin helps businesses evaluate operation efficiency

Net profit margin 

Net profit margin is calculated based on after-tax profit earned from production and business activities. This metric shows the ratio between net income and sales.

Formula for calculating net profit margin:

Net profit margin = Net profit after tax / Revenue

Example: Company A's net profit after tax is VND 100 million, revenue is VND 400 million, then net profit margin = 100,000 000 / 400,000,000 = 25%

Net profit margin is the profit earned by the business in production and business activities

Investors rely on the profit margin index to decide whether to invest into a business or not. Based on this index, investors can clearly know and understand the amount of money the business earns from total revenue. Investors make decisions based on comparing the profitability of each business to make the best choice.

Profit margin is the basis for investors to consider whether or not to invest