Which of the following statements is a method for improving net profit margin?

Profit margin is the percentage of sales that a business retains after all expenses have been deducted. In essence, it shows the proportion of each dollar of sales that is retained as earnings. For example, a 15% profit margin indicates that a business is retaining $0.15 from each dollar of sales generated. Profit margin is a key indicator of the financial health of a business. There is continual pressure on management by shareholders to increase the profit margin to the greatest extent possible, since doing so tends to drive up the stock price.

How to Calculate Profit Margin

The calculation of the profit margin is sales minus total expenses, which is then divided by sales. The calculation is expressed as follows:

(Sales - Total expenses) ÷ Sales 

Dividends paid out are not considered an expense, and so are not included in the profit margin formula.

Presentation of Profit Margin

Profit margin is reported in an organization’s income statement. The gross margin (sales minus the cost of goods sold) is reported just below the cost of goods sold line item. The operating profit margin appears lower in the income statement, just after the selling, general and administrative expenses section. Finally, the profit margin appears at the bottom of the income statement, after all financing-related line items and taxes. This reporting is typically conducted on a monthly, quarterly, and/or annual basis. A publicly-held business is required to report its profit margin to the public on a quarterly basis.

Example of Profit Margin

ABC International incurs expenses of $1,900,000 on sales of $2,000,000 in its most recent reporting period. This results in the following profit margin:

($2,000,000 Sales - $1,900,000 Expenses) ÷ $2,000,000 Sales

= 5% Profit margin

Types of Profit Margin

There are four types of profit margin, which are the gross margin, operating margin, pre-tax margin, and after-tax margin. They are described further in the following sub-sections.

Gross Margin

The gross margin is net sales minus the cost of goods sold. It is best expressed as a percentage of net sales and tracked on a trend line, in order to see whether a business is able to maintain or enhance its margins over time. If not, there is a good chance that either its prices are eroding due to increased competition, or its costs are increasing. Gross margins tend to decline in highly competitive markets.

A company’s gross margin represents the summation of the margin for each individual product. This means that, when a company sells a number of products with differing margins, the gross margin will be impacted by changes in the mix of product sales from month to month. For example, if a company runs a special discount deal that emphasizes the sale of a product with a low margin, the increased volume of its sales will skew the overall gross margin of the company downward; this is because a higher proportion of goods is being sold with a lower margin.

Operating Margin

The operating margin is the gross margin minus all selling, general and administrative expenses. This is an important ratio, because it indicates whether the core operations of a business are able to generate a profit on a consistent basis. If not, it is possible that the firm will need to be substantially restructured or closed down. A business is more likely to have a robust operating margin when it has targeted a niche market in which it has a smaller number of competitors.

Pre-Tax Margin

The pre-tax margin is the operating margin, plus or minus all non-operating expenses, gains and losses. For example, interest income and interest expense will be included in the calculation of the pre-tax margin, as will payouts related to unfavorable lawsuit settlements.

After-Tax Margin

The after-tax margin is the pre-tax margin, minus any income taxes. This is the “bottom line” of a business, since it indicates whether a firm is able to generate a profit after all expenses have been accounted for. This can be quite a small percentage as a proportion of net sales.

What is a Good Profit Margin?

Profit margins vary dramatically by industry. When inventory levels turn over very slowly (such as in an art gallery), margins have to be very high, since so few items are being sold. However, when inventory turnover is more rapid (such as in a supermarket), a business can afford to generate much lower profit margins, since it is selling more units. Consequently, what constitutes a good profit margin depends on the situation. That being said, a 5% profit margin would generally be considered on the low end of the acceptable range. A business that can generate 20% returns is solidly profitable.

Some industries are able to persistently generate high profit margins, including software, pharmaceuticals, and makers of luxury goods. These industries are able to gain an advantage by branding their products or providing goods or services that cannot be obtained elsewhere. Other industries are usually mired in low profits, such as farming operations. These industries produce commodity goods, and so are forced by unrelenting competition to keep their prices low.

How to Improve Your Profit Margin

The profit margins generated by businesses within the same industry tend to be quite similar, since they all sell at roughly the same price points and have the same types and amounts of expenses. An organization can diverge from this average profit margin by emphasizing sales in specialty niches, as well as by using such restructuring techniques as outsourcing production, minimizing the investment in inventory, and shifting to a low-tax region.

Another possibility for improving your profit margin is to compare the company’s operations to those of a best-in-class business, perhaps in a different industry. This comparison may reveal a number of operational improvements that can be made, resulting in an improved profit margin.

Yet another possibility for improving your profit margin is to concentrate on maximizing the utilization of the company’s bottleneck operation. By increasing the flow of goods through the bottleneck, a business should be able to generate higher profits. Increased utilization can be achieved by working the bottleneck operation for multiple shifts, overstaffing it to ensure that there are always enough people on hand to run it, and increasing the inventory buffer in front of it, so that it never runs out of raw materials.

Reasons for a Decline in Profit Margin

A common situation is for a business to initially grow within a profitable niche, which the entity maximizes to the greatest extent possible. Management is then under investor pressure to continue growing sales, so it expands outside of its original niche, into less profitable areas. The result is an increase in sales, but a lower profit margin as the organization continues to expand.

Another reason for a decline in profit margin is the gradual increase in corporate overhead that naturally occurs as a business increases in size. The extra staffing may be needed for risk management, litigation support, internal auditing, and so forth. These additional costs are usually only added at long intervals, so the modest decline in profit margin that they trigger may not be especially noticeable until a number of years have passed.

Profit Margin vs. Cash Flow

Profit margin is revenues minus expenses, which is an accounting concept that does not necessarily relate to the amount of cash generated by a business. An organization can report robust profits while running out of cash, since it requires a great deal of cash to increase sales in most industries. There can also be timing differences that create an imbalance between profits and cash flows. For example, a retailer places a huge order with 90-day payment terms; the result for the seller is a large booked profit, and no associated incoming cash flows until the 90-day period is over. In short, one should be cognizant of both the profit margin and cash flows when evaluating a business.

Which of the following is a method for improving net profit margin?

Which of the following statements is true regarding profit margin?

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