3.2.4. Profit Margins
Profit margin is yet another measure of profitability. As with earnings, there are multiple ways to calculate profit margin. However it is calculated, profit margin is a useful metric for examining a company’s performance over time or for comparing the performance of companies within the same industry. It is less useful for comparing companies in different industries, since typical cost structures, and therefore margins, vary widely from one industry to another.
The gross profit margin provides information about the relationship between the cost of goods sold and net revenues. Gross margin can be expressed as an absolute number, in which case it means the same thing as gross profit. Gross margin is more often and more usefully expressed as a ratio or percentage. Used in this way, gross margin expresses what percentage of each dollar of sales can be used for overhead, debt service, and other expenses not directly related to the production of goods and services.
To calculate gross margin, first obtain the figures for revenues and gross profit from a company’s income statement. If the income statement does not include gross profit as a line item, derive gross profit by subtracting COGS from net revenues. Then plug the numbers into the following equation:
SAMPLE QUESTION
A company has revenues of $10 million. Its cost of goods sold is $7 million. What is the company’s gross margin?
Answer: 30%. Gross margin = gross profit / net revenues. The company’s gross profit is $3 million ($10 million – $7 million). Dividing the gross profit by revenues ($3 million / $10 million) gives a gross margin of 0.3, or 30%.
The operating profit margin indicates the percentage of each dollar of sales that is left over after the company pays the cost of goods sold and its op