A profit margin, also called a net income margin, is a financial ratio used to evaluate a company’s profitability. When a company has a high profit margin, it means that a high percentage of each dollar generated by the company in revenue is actual profit. For example, a profit margin of 19 percent means that 19 cents out of every dollar of revenue is profit for the company. In order to create a high profit margin, companies must actively curtail costs, strategically price their products and services, and fend off competition. The percentage constituting a high profit margin varies between industries and sectors, limiting the use of the profit margin to internal comparison or comparison between companies in the same industry.
Accountants and business managers calculate the profit margin using financial information pertaining to a limited period. First, the costs of sales, operating costs, and overheads are subtracted from the total revenue. Second, any interest payable and refunds are subtracted. The resulting value is the net profit. An accountant can then derive the profit margin by dividing the net profit by the total revenue and multiplying the value by 100 to obtain a percentage.
The pricing strategy of a company can be a significant contributor to a high profit margin. In choosing the right price for a product or service, the company must, first and foremost, place a high enough price to recover all costs. A price, however, must not be set so high that it turns off customers. Other considerations in pricing include the product demand, the product quality, the advertising and promotional plans for the product, and the distribution of the product. The boundaries of a well-determined price are the price floor, at which the company experiences a loss with the sale of the product, and the price ceiling, at which customers refuse to buy the product.
Another ratio used to evaluate company productivity is the gross profit margin. The top number of this ratio is gross profit, defined as the total revenues minus the costs of goods sold. Like the profit margin, the bottom of the ratio is the total revenues amount. Because the gross profit margin should remain relatively stable over time, substantial fluctuations are red flags for possible accounting abnormalities or fraudulent activity. When obtained using the gross margin calculation, a high profit margin points to an organization that should be able to make a reasonable net income, with money left over for dividends, as long as the company controls its costs.