Definition of Profit Margin, Types, and How to Calculate It

Profit margin is an important component in the financial reports of a business or company.

The profit margin is an important element in company operations, including the financial audit process.

With a profit margin, you can know the company’s profit level.

Has it reached the target, less than the target, or even more?

Let’s dive right into Avitro’s article on profit margin for better understanding of it.

What is Profit Margin?

Profit margin, is a profitability ratio that is calculated by comparing profit after interest and tax with sales.

The result of profit margin is the profit obtained from sales.

Simply put, if the company’s profit or profits are high, then the company is working well, as is its financial management.

But on the other hand, if profits are low, then the company’s profitability is considered unsafe.

This certainly affects inventor’s interest in the company.

Benefits of Profit Margin

Profit margin certainly plays a very important role for the company.

A number of benefits that you need to know about having a profit margin are as follows:

1. Demonstrate financial performance

By using the profit margin formula, you can find out the company’s financial performance in general, especially regarding profit.

That way, you can see and decide whether the company is working well or not.

2. Has an impact on investors and prospective investors

Another benefit of profit margin is that it serves as a reference for investors in assessing the suitability of a company to receive capital assistance from them.

3. As a reference for evaluation

For company management, profit margin is material for evaluating and looking at problems that affect business continuity.

The existence of a profit margin will help the company solve or overcome problems appropriately.

Types of Profit Margin

Profit margins can be divided into several types.

In simple terms, profit margin can be divided into gross profit margin and net profit margin.

Let’s talk about them one by one:

1. Gross profit margin

Gross profit margin is the most basic way to calculate profitability because it defines profit as the remaining income after calculating COGS (cost of goods sold).

COGS refers to any costs incurred in the production process, such as the price of shoulder materials and wages paid during the process.

Gross profit margin is a starting point for analysis to achieve a healthy net profit.

The higher the gross profit margin, the faster a business will reach its break-even point.

In this way, profits from basic business activities can also be obtained more quickly.

Even so, strategies are still needed in competition and pricing.

Don’t let the company sacrifice sales to obtain a high gross profit margin.

The formula for calculating gross profit margin is as follows:

GPM = (Sale – HPP) / Sale

2. Net Profit Margin

Net profit margin, or net profit margin, is a profit calculation ratio for assessing the percentage of profit minus income tax from sales proceeds in a certain time period.

If the net profit margin is high, it means that the company’s operations are also getting better.

Therefore, this margin can also be used as a reference for measuring your company against other companies when calculating profits.

Quite different from gross profit margin, the way to calculate net profit or net profit margin is to use the following formula:

NPM = net profit after tax / net sales

How to Calculate Profit Margin

As previously explained, the profit margin formula consists of several types.

Net profit margin and gross profit margin are the two most frequently used formulas.

To make it easier to understand the two formulas above, below are the examples of profit margin cases and how to calculate them.

Case 1:

Ahamat Enterprises generated total sales of 200,000 Naira with production costs of 120,000 Naira.

So, the way to calculate the net profit margin is as follows:

NPM = net profit after tax / net sales

=  (200,000 – 120,000) / 200,000

=  80,000 / 200,000

=  0.4 (40%)

So, the total net profit margin is 40%.

Case 2:

Ahamat Stores generated total bag sales in 2023, reaching 200,000,000 Naira.

Meanwhile, the cost of goods sold (HPP) is 20,000,000 naira.

So, the way to calculate gross profit margin is as follows:

GPM = (Sale – HPP) / Sale

= (200,000,000 – 20,000,000) / 200,000,000

= 180,000,000 / 200,000,000

= 0.9 (90%)

So, the total net profit margin is 90%.

Conclusion

That’s an explanation of profit margin and how to calculate it in a simplest term with clear case studies.

Hopefully, this can help you measure the profits from the business you are running.

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