Profit margin is one of the commonly used profitability ratios to gauge the degree to which a company or a business activity makes money. It represents what percentage of sales has turned into profits. Simply put, the percentage figure indicates how much of profit the business has generated from sale.
Businesses and individuals across the globe perform for-profit economic activities with the aim to generate profits. However, absolute numbers—like $A million worth of gross sales, $B thousand business expenses, or $C earnings—fail to provide a clear and realistic picture of a business’s profitability and performance. Several different quantitative measures are used to compute the gains (or losses) a business generates, which makes it easier to assess the performance of a business over different time periods or compare it against competitors. These measures are called profit margins.
Gross profit margin: Start with sales and take out costs directly related to creating or providing the product or service like raw materials, labour, and so on—typically bundled as “cost of goods sold” or “cost of sales” on the income statement—and you get gross margin. Done on a per-product basis, gross margin is most useful for a company analysing its product suite, but aggregate gross margin does show a company’s rawest profitability picture.
Equation: Gross profit margin = (Net sales – Cost of Goods Sold) / Net sales
A closer look at the formula indicates that profit margin is derived from two numbers—sales and expenses. To maximize the profit margin, which is calculated as {1 – (Expenses/ Net Sales)}, one would look to minimize the result achieved from the division of (Expenses/Net Sales). That can be achieved when Expenses are low and Net Sales are high.
Source: Investopedia
