Also known as the margin of profit, a profit margin is simply the difference between sales generated and the cost to produce each of the units sold. The ratio is sometimes defined as a gross or net profit margin, depending on the nature of the data that is under consideration. Businesses of all types pay close attention to these margins, since they provide invaluable information that helps to assess the current financial status of the company.
The profit margin ratio can be calculated in several different ways. In most applications, the ratio requires that the total cost of producing a good or service must be determined. This means accounting for the costs associated with raw materials, production equipment, salaries and wages of those involved in the production, packaging costs, and marketing expenses. Once the company has determined exactly how much it costs to produce one unit of this good or service, it is possible to set a price for the unit. The difference between the sales price and the cost of producing that one unit is the profit margin on that particular unit.
In most cases, an operating profit margin is presented in terms of a percentage. For example, if a company generated sales of $5 billion US Dollars (USD) and it cost the company $3 billion USD to produce those goods, the company would have a profit of $2 billion USD. That amount would be presented as a 40% profit margin.
There is some difference of opinion when it comes to the inclusion of labor costs in determining this margin. One school of thought is that labor costs should not be reflected in any assessment that is aimed at determining the gross profit. Instead, the figure can be accounted for when it becomes time to calculate the net profit. A different approach prefers to include all identifiable expenses related to the production process in the total cost, stating that this helps to simplify the calculation of a true margin.
In either incarnation, taking the time to calculate the profit margin for a product line or even for a company as a whole is essential to determining if a company is growing, maintaining its current market share, or is losing customers and is in danger of not making a profit. Many companies choose to look at profit margin ratios on a regular basis, just to make sure that sales are headed in the right direction, and that expenses are being contained in order to maximize the returns from those sales. If the margins begin to drop, the business can take steps to identify the reason or reasons for the change, and restore a healthier margin.