Understanding profit margins

Profit margins express – in values or percentage terms – what returns a company makes on the sale of its goods or services.

Let’s take a simple profit & loss account to illustrate the point:

ABC LTD

PROFIT & LOSS ACCOUNT

YEAR ENDED 31 DECEMBER 2018

Gross profit

Gross profit is the return a company makes on its sales, after deducting the costs that are directly associated with producing the goods or services, but before distribution costs and other overheads.

In the above example, gross profit in absolute terms is £500,000. The Gross Profit Margin expresses the relationship between gross profit and turnover in percentage terms. £500,000 / £1,500,000 expressed as a percentage is 33.33%, so ABC Ltd has made a 33% Gross Profit Margin in 2018.

To run a business successfully it’s crucial to understand how profit margins work, for a number of reasons:

• When pricing your products or services you need to understand what the margins are, so that you can determine the financial consequences and understand the implications in terms of the volumes of sales that need to be achieved to cover overheads and make the target overall return;
• By understanding how margins work you can more readily understand the impact of different pricing decisions – for example the impact of a 10% discount on the top line has a very different impact on the gross profit (and indeed the net profit), depending on whether you are dealing with a relatively high or low margin product;
• By paying attention to the margins on individual product/ service lines, insights can be gained into which products generate the best (and poorest) returns, which might lead to a shift in market focus, marketing activity or any other number of quite critical decisions;
• Focusing on margins may help highlight where there are cost pressures on the supply side that could indicate a need to raise prices to protect profitability;
• Profit margins can be used to compare performance trends in the business over extended time periods; they can also be used to benchmark the business against competitors or industry standards (where known).

Gross profit receives most of the attention when it comes to product pricing, but operating profit and net profit are similarly important and the diligent small business owner will have a firm grasp on these numbers too.

Operating profit

Operating profit is the return a company makes on its sales, after deducting all costs except finance costs (e.g. loan interest) and taxation. Operating Profit Margin expresses the relationship between operating profit and turnover in percentage terms. In the example of ABC Ltd, operating profit is £150,000 and the Operating Profit Margin is £150,000 / £1,500,000 expressed as a percentage = 10%.

Operating profit is an important measure because it explains how good the company is at turning sales into profits. For investors and creditors, this is of considerable interest. Companies need to generate sufficient operating profits to be able to provide an adequate return to investors, fulfil debt repayment obligations and meet the requirements of loan covenants.

If operating profits do not meet expectations, business owners can interrogate further by examining turnover, Gross Profit/ Margin, and distribution costs/ administration expenses.

Net profit

Net profit is the return a company makes on its sales, after deducting finance costs. It can be calculated on profits before or after tax – it always important to be clear which of these measures is used.

The Net Profit Margin expresses the relationship between net profits and turnover in percentage terms. In our example, net profit (after tax) is £80,000 and the Net Profit Margin (after tax) is £80,000 / £1,500,000 expressed as a percentage = 5.33%.

Net profit is important for shareholders because their returns are based on capital growth (in the value of their shares, if there is a market for those shares) and dividends, which are financed out of the net profits of the business, after for providing for taxation.

Margin versus mark-up

One area that can cause confusion is the difference between margin and mark-up.

Returning to ABC Limited once more, as we have already seen the Gross Profit Margin is 33%. But what about the mark-up? Mark-up expresses the amount by which a product’s selling price exceeds its production cost. In our example, the average mark-up is £500,000 / £1,000,000 expressed as a percentage = 50%.

The direct relationship between margin and mark-up is crucial to understand when pricing your products or services:

Mark-up % = (Gross Profit / Costs of sale) x 100

Gross Profit £ = Mark-up % x Costs of sale £

Monitoring

Profit margins should be closely monitored and corrective action taken on a timely basis where necessary. Using modern accounting software like Quickbooks and Futrli can be of real benefit here, making monitoring activities more efficient, timely and intuitive.

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