Profit Margin
What is Profit Margin?
The Difference Between Profit and Profit Margins
Profit is the amount of money kept after taking out expenses. The profit margin is the percentage of each revenue dollar left after paying for expenses. This is a scalable ratio. It's how we’re able to compare two entities even though they are different sizes. There are three main types of profit and profit margin: gross, operating, and net.
Gross Profit and Profit Margin
Gross profit is the dollar amount kept after paying for the cost of goods sold. The percentage of each dollar earned after paying for COGS is the gross profit margin. Gross profit is a perfect starting point for building a budget. It's the money available to spend on operating and administrative costs after paying to produce or buy inventory.
Use the gross profit margin to analyze stock acquisition processes. You can identify areas of opportunity to improve efficiency and increase profits.
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GROSS PROFIT = REVENUE - COGS
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GROSS PROFIT MARGIN = GROSS PROFIT / REVENUE
We pay our employees $15 per hour and One T-Line employee can produce 3 shirts in an hour. That means it costs us $5 per shirt in labor. It also takes 3 yards of fabric at $2 per yard and two spools of thread that are $1.50 each. Our total COGS per shirt is $13. The shirts sell for $20 apiece and, as we mentioned earlier, T-Lines sells its whole inventory each month.
On average, we make 2,640 per month. That's a revenue of $52,800 and a COGS of $34,320 in total.
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$52,800 REVENUE - $34,320 COGS = $18,480 GROSS PROFIT
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$18,480 GROSS PROFIT / $52,800 REVENUE = 35%
Operating Profit and Operating Profit Margin
Revenue minus COGS and operating costs are the operating profit. The percentage of income left after removing those items is the operating profit margin. Operating profit tells you how much you have left to spend after paying for the cost of doing business. The operating profit margin highlights areas of improvement in management and infrastructure.
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OPERATING PROFIT = REVENUE - (COGS + OPERATING COSTS)
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OPERATING PROFIT MARGIN = OPERATING PROFIT / REVENUE
T-Lines has the following monthly operating costs:
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$500 for maintenance services
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$2,000 for rent
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$1,000 in utilities
That's a total of $3,500 in operating expenses.
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$52,800 REVENUE - ($34,320 COGS + $3,500 OPERATING COSTS) = $14,980 OPERATING PROFIT
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$52,800 REVENUE / $14,980 OPERATING PROFIT = 28% OPERATING PROFIT MARGIN
Net Profit and Net Profit Margin
When you remove all expenses including administrative costs, you're left with a net profit. The percentage of each profit dollar that remains is the net profit margin.
Net profit is your bottom line.
Analyze your company's gross and operating profits to identify weaknesses. Then make a budget with your net profit to enact the changes necessary to improve profit and drive growth. Net profit margins give you a broad overview of your company's health. Even if you meet gross and operational goals, a positive net profit is still needed to make money.
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NET PROFIT = REVENUES - (COGS + OPERATING COSTS + ADMINISTRATIVE COSTS)
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NET PROFIT MARGIN = NET PROFIT / REVENUE
T-Lines' administrative costs include $1,500 in employee taxes and a debt that we pay down by $500 per month.
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$52,800 REVENUE - ($34,320 COGS + $3,500 OPERATING COSTS + $2,000 ADMINISTRATIVE COSTS) = $12,980 NET PROFIT
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$12,980 NET PROFIT / $52,800 REVENUE = 25% NET PROFIT MARGIN
What Healthy Profit Margins Look Like
There's no standard for what profit margins should be like because it's based on the industry average. What looks good for one business may be detrimental to another. A good profit margin is one that's better than that of the industry standard.
The average gross profit margin for apparel is 49.52% according to NYU's Stern Database. At first, glance, T-Lines' gross profit margin of 35% may look a little low, but we're a brand new company. Many businesses take up to three years to turn a profit.
How to Use Profit Margins to Identify Areas of Opportunity
You can use profit margins to identify areas of opportunity and make informed decisions that influence growth. The best way to explain how is to provide an example. We already know that T-Lines has room to improve its efficiency in its production process. T-Lines has 5 employees each makes 528 shirts per month. We can improve our gross profits if we produce more shirts each month. There are three choices:
A.) Hire a New Employee
If T-Lines hires a new employee, the output will change from 2,640 shirts per month to 3,168. The COGS per unit doesn't change, but our labor costs increase COGS to a total of $41,184.
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Revenue goes up to $63,360
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$63,360 REVENUE - $41,184 COGS = $22,176 GROSS PROFIT
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$22,176 GROSS PROFIT / $63,360 REVENUE = 35% GROSS PROFIT MARGIN
Since the cost of goods doesn't change and still manage to sell our entire stock, the gross profit margin doesn't change. This isn't looking like our best decision.
B.) Change Processes to Increase Efficiency
A T-Lines employee comes to us with some ideas for improving production efficiency. We review the suggestions and decide to move forward with the changes.
After a few months, we run the numbers again and see significant improvement. Our employees can now make five shirts per hour instead of the original three. This changes the cost of goods sold from $13 to $11.
The average units made per month also changes. We're now able to make 4,400 shirts per month. That's even better than if we hired a new employee and we're still able to sell everything! At this rate, we're looking at a total COGS of $48,400 and a revenue of $88,000.
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$88,000 REVENUE - $48,400 COGS = $39,600 GROSS PROFIT
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39,600 GROSS PROFIT / $88,000 REVENUE = 45% GROSS PROFIT MARGIN
That's a huge step toward meeting the industry average of 49.52%.
C.) Both
After the success, we enjoyed changing our processes, and we also hired a new employee. Based on our initial findings, we know it won't impact our gross profit margin. Still, a new employee will help us increase production. With the help of our new employee, we make 5,280 shirts in a month. Unfortunately, we're only able to sell 4,800.
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$96,000 REVENUE - $58,080 COGS = $37,920 GROSS PROFIT
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$37,920 GROSS PROFIT / $96,000 REVENUE = 40% GROSS PROFIT MARGIN
In this case, having an extra employee actually hurts our bottom line.
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