Profit Margin: Meaning, Types, Uses, and How to Improve

Understanding profit margin is essential for any business, no matter the industry. Gross profit percentage reflects how much money is left after covering the costs of producing goods or delivering services.

At its core, profitability simply measures the gap between what a business earns and what it spends.

While raising prices or selling more are common strategies to increase earnings, they’re not the only ways. By analyzing your financial performance, you can uncover inefficiencies and explore smarter approaches to maximize returns.

This article will explain the meaning of profit margin, its uses, examples, and how to improve it so that your business can gain steady revenue and grow even better in the future.

What is Profit Margin?

Profit margin is a widely used metric to determine how much profit a company or specific business activity generates. Represented as a percentage, it shows the portion of sales revenue retained as profit after deducting all expenses.

For instance, if a company in Malaysia reports a 25% profit margin for the last quarter, it means it earned RM0.25 from every ringgit of sales. A company’s income statement presents profits in the following order:

1. Sales revenue is recorded first, followed by the deduction of direct production costs, leaving the gross profit.
2. Next, indirect costs such as office expenses, advertising, and R&D are subtracted, resulting in the operating profit.
3. Then, interest on debt and any unusual gains or losses unrelated to core business activities are factored in, yielding the pretax profit.
4. Finally, taxes are deducted, leaving the net profit or net income, which is the bottom line.

A study found that profitability is positively linked to efficiency. Therefore, increasing profit margin should be the priority of every company if they want to advance forward (however, don’t neglect other aspects as well, since many factors contribute to a company’s growth).

How Profit Margin Works

Businesses and individuals worldwide engage in economic activities to generate profit. Figures such as $X million in gross sales or $Y million in earnings provide useful information but do not fully capture a business’s profitability or comparative performance.

To measure profit, businesses use different methods that help track performance over time or compare with competitors. Profit margins are one of the most important numbers investors check before investing.

Small businesses, like local shops, can calculate their profit margins whenever they want, such as weekly or monthly. However, big companies that are publicly listed must report their profit margins every three months or yearly.

If a business has loans, banks may require them to report their profit margins monthly.

Types of Profit Margin

Although the net profit margin is the most well-known and widely used measure, there are actually four types of profit margins, each based on a different type of profit:

1. Gross Profit Margin

Gross profit is the amount left after subtracting the cost of goods sold (COGS) from revenue. COGS includes the direct costs of producing goods or services, such as raw materials, labor, and factory overhead.

Formula for gross profit:
Gross profit = revenue – cost of goods sold

To calculate the gross profit margin:
Gross profit margin = (gross profit ÷ revenue) x 100

Gross profit margin helps evaluate the profitability of individual products or services rather than the entire business. A company might have strong sales but still face losses if operating expenses are too high. Calculating gross margin reveals whether too much effort or cost is being spent on a specific offering.

2. Operating Profit Margin

Operating profit is the income left after deducting both COGS and operating expenses (OPEX). While COGS covers production costs, OPEX includes expenses like rent, payroll, marketing, and software. However, it doesn’t account for interest or taxes.

Formula for operating profit:
Operating profit = revenue – cost of goods sold – operating expenses

To find the operating profit margin:
Operating profit margin = (operating profit ÷ revenue) x 100

For a more comprehensive view of profitability, consider using the operating or net profit margin. Operating profit is often referred to as EBIT (Earnings Before Interest and Taxes) in financial statements.

3. Net Profit Margin

Net profit is the final amount left after deducting COGS, OPEX, interest, and taxes from revenue.

Formula for net profit:
Net profit = revenue – cost of goods sold – operating expenses – interest – taxes

To calculate the net profit margin:
Net profit margin = (net profit ÷ revenue) x 100

Net profit margin is one of the most reliable indicators of profitability since it includes all significant direct and indirect costs. It’s often referred to as the “bottom line” on the income statement, summarizing a company’s earnings and expenses over time.

4. Pretax Profit Margin

Pretax profit is the income remaining after deducting all expenses except for taxes. It accounts for costs like COGS, operating expenses, and interest, giving a clear picture of profitability before taxes are considered.

Formula for pretax profit:
Pretax profit = revenue – cost of goods sold – operating expenses – interest

To calculate the pretax profit margin:
Pretax profit margin = (pretax profit ÷ revenue) x 100

Pretax profit margin is useful for comparing profitability across businesses in different regions or industries with varying tax rates. It helps identify how efficiently a business generates profit before tax obligations are factored in.

What’s a Good Profit Margin?

Determining a “good” profit margin depends significantly on the industry in question. Profit margins can vary widely across different sectors due to varying cost structures, competition levels, and market conditions. For instance, in the United States:

• Banks (Money Center): As of January 2024, this industry had a net profit margin of approximately 30.89%.
• Auto & Truck: Reported an average net profit margin of around 3.96%.
• Beverage (Soft): Had a net profit margin of about 14.47%.

Given these variations, it’s essential to compare a company’s profit margins with industry-specific averages to assess performance accurately. While a 10% net profit margin might be average in some industries, it could be considered high in others and low in different sectors.

Profit Margin Formula and Example Calculation

ABC Printing Sdn Bhd operates in Malaysia, specializing in custom-printed t-shirts. In 2023, the company generated RM700,000 in revenue from sales. The cost of goods sold (COGS), which includes materials and production costs, was RM200,000.

Operating expenses, such as rent, salaries, utilities, and taxes, amounted to RM400,000. Let’s calculate the gross and net profit margins.

Income Statement:

• RM700,000 revenue
• (RM200,000) cost of goods sold
• RM500,000 gross profit
• (RM400,000) other expenses
• RM100,000 net income

So, the calculation would go like this:

1. Gross Profit Margin:
   • Formula: (Gross Profit ÷ Revenue) x 100
   • Calculation: (RM500,000 ÷ RM700,000) x 100 = 71.4%
2. Net Profit Margin:
   • Formula: (Net Income ÷ Revenue) x 100
   • Calculation: (RM100,000 ÷ RM700,000) x 100 = 14.3%

ABC Printing Sdn Bhd achieved a 71.4% gross profit margin, showing strong profitability after production costs. However, with a 14.3% net profit margin, it indicates that other expenses significantly impacted overall profitability.

This suggests opportunities to optimize operating expenses for better performance.

How to Determine Profit Margin

To calculate your profit margin, follow these steps:

1. Find Your Total Costs: Add up all costs related to producing or acquiring the product, including materials, labor, and overhead. If the total cost is RM50 per item, write it down.
2. Set Your Selling Price: Decide on the price you plan to sell the product for. Say that you choose RM80 as your selling price.
3. Calculate Profit: Subtract the total cost from the selling price to find your profit.
   1. Formula: Profit = Selling Price – Total Costs
   2. Example: RM80 – RM50 = RM30 profit.
4. Determine Profit Margin: Divide the profit by the selling price and multiply by 100 to get the percentage.

1. Formula: Profit Margin = (Profit ÷ Selling Price) x 100
2. Example: (RM30 ÷ RM80) x 100 = 37.5% profit margin.

Uses of Profit Margin in Business and Investing

From large corporations to your neighborhood nasi lemak stall, profit margin is a metric businesses across Malaysia and the world rely on. It also serves as an indicator of profitability trends in larger industries and national or regional markets.

You might see headlines like “XYZ Research highlights shrinking profit margins in Malaysia’s retail sector” or “ASEAN corporate profit margins hit record highs.” But what do those statements actually mean? The explanation is as follows:

1. Global Benchmark for Profitability: Profit margin is a universally recognized indicator of a business’s ability to generate profit. It’s a key figure featured in quarterly financial reports, providing a high-level view of a company’s potential.
2. Operational Tool for Business Owners: Business owners, management, and consultants rely on profit margins to identify and address inefficiencies. For instance, a zero or negative margin signals issues like unsold inventory, excess staff, or high operational costs. This insight helps devise targeted action plans.
3. Assessing Performance Across Divisions: Companies with multiple divisions, product lines, or facilities across different locations use profit margins to evaluate each unit’s performance and compare them to one another, ensuring consistent growth and efficiency.
4. Crucial for Funding and Loans: Smaller businesses, like local retail stores, use profit margins to secure or restructure loans. Large corporations raising funds through debt or IPOs must reveal their intended capital use, with profit margins providing key insights to lenders and investors.
5. Investor Decision-Making: Profit margins are a vital metric for investors when comparing companies. A higher margin indicates efficient management and the potential for better returns, making the business more attractive to stakeholders.

In summary, profit margins are an indispensable tool for businesses and investors to evaluate financial health, address challenges, and drive decisions. Small businesses, like local retail stores, can also benefit from tools like invoicing software to manage cash flow and track profitability.

How to Improve Profit Margin

Boosting profitability involves increasing revenue, cutting costs, or combining both strategies. Here are practical ways to achieve your desired profit margin:

• Lower operating expenses: Evaluate costs like office space, utilities, wages, insurance, and software. Negotiate better rates, downgrade services, or eliminate unnecessary expenses.
• Refine your product or service mix: Use break-even analysis to identify unprofitable offerings. Focus on high-margin products or explore industry trends for ideas. Balance your costs and pricing to maximize returns.
• Adjust pricing strategies: Experiment with approaches like value-based or cost-plus pricing to find what works best. Pricing changes can significantly influence demand.
• Strengthen brand loyalty: Engage with customers and show appreciation to boost retention. Loyal customers reduce the need for heavy advertising, lowering your expenses.
• Use automated system: Using tools like accounting software in Malaysia, businesses can simplify expense tracking and improve efficiency

Examples of High and Low Profit Margin Industries

Profitability varies widely across industries due to differences in costs, competition, and market dynamics. Here’s a look at industries with typically low and high profit margins.

Low Profit Margin Industries

Below are the examples of low profitability industries:

1. Grocery Stores

Grocery stores like Tesco and Giant in Malaysia often operate with very slim profit margins. This happens because they face tough competition, which forces them to keep prices low. They also have high costs for things like inventory, logistics, and wages. To stay profitable, they rely on selling in large volumes instead of charging high prices.

2. Restaurants

Restaurants, such as casual dining chains or local food stalls, also have low profit margins. The cost of fresh ingredients, rent, staff wages, and utilities adds up quickly. On top of that, competition in the food industry is fierce, so restaurants need to keep their prices affordable, making it harder to earn big profits.

3. Transportation and Logistics

Industries like shipping and ride-hailing often struggle with low margins. High costs for fuel, vehicle maintenance, and operations eat into profits. For instance, ride-hailing platforms lower fares to attract more customers, but this also reduces their overall profitability.

4. Automotive

Car manufacturers, especially those producing mass-market vehicles, face low margins because of high production costs. They also compete heavily with discounts and promotions, which makes it difficult to earn significant profits despite large sales volumes.

High Profit Margin Industries

Here are some industries that are considered to have high margin due to several factors:

1. Software and Technology

Software companies offering services like cloud computing or SaaS enjoy high profit margins. These businesses sell the same product repeatedly, like enterprise software, without needing to spend a lot on each new customer.

2. Pharmaceuticals

Pharmaceutical companies, particularly those with patented drugs, make large profits. For example, they benefit from exclusivity and high demand for essential medicines. Patents give them the power to set prices higher, ensuring strong profit margins.

3. Tobacco Industry

Tobacco companies, like British American Tobacco, consistently achieve high margins. Their products are cheap to make but sold at premium prices. Regulations also limit competition, allowing these companies to maintain strong profitability.

4. Luxury Goods

Brands like Louis Vuitton and Rolex are known for their high margins. They cater to customers willing to pay extra for exclusivity and branding. Their strong loyalty and minimal competition in the luxury space make them incredibly profitable.

5. Oil and Gas

Oil and gas companies, such as Petronas, experience fluctuating margins. When oil prices are high, profits soar. However, during price dips, their massive operational costs, like refining and exploration, can lower profitability.

Boost Your Profit Margin with HashMicro Accounting Software

Understanding and improving profit margins is key for any business looking to boost profits. But keeping track of expenses, revenues, and operating costs manually can be a hassle and lead to mistakes. That’s where accounting software steps in to make things easier.

HashMicro’s Accounting Software provides an all-in-one solution for managing your finances effortlessly, fully compliant with Malaysian tax regulations and equipped with Business Intelligence (BI) tools for smarter decision-making.

Key features include:

• Profit & Loss vs. Budget & Forecast: Compares actual profit and loss figures with predefined budgets and forecasts to track financial deviations.
• Financial Statement with Budget Comparison: Provides a side-by-side view of actual financial performance against budgeted amounts for precise financial tracking.
• Multi-Level Analytical: Allows filtering and analyzing financial data by categories like projects or branches for a detailed breakdown.
• Bank Integration – Auto Reconciliation: Matches bank transaction data with internal records to ensure consistent and accurate bookkeeping.
• Cash Flow Reports: Generates reports that detail all cash inflows and outflows over a specific period for financial oversight.

Conclusion

Profit margin is a key measure of a company’s profitability, showing how efficiently it generates profit. Understanding these metrics helps companies make better decisions to achieve sustainable growth.

Managing profit margins manually can be tedious and error-prone, but HashMicro’s Accounting Software simplifies the entire process. Designed to comply with Malaysian tax regulations, it automates tracking expenses, revenues, and financial data.

HashMicro’s Accounting Software is more than just a tool. It’s also your partner in achieving financial clarity. Equipped with Business Intelligence, it empowers you to analyze trends and optimize your profit margins.

Whether you’re running a local store or a large corporation, this software helps you make smarter decisions effortlessly. So, interested yet? Try the free demo now!

FAQ on Profit Margin

• How do profit margins vary across different industries?

  Profit margins can differ significantly between industries due to varying cost structures and competitive environments. For example, software companies often have higher profit margins compared to retail businesses.

• What factors can cause profit margins to fluctuate over time?

  Profit margins may fluctuate due to changes in production costs, pricing strategies, market demand, and economic conditions. One-time events like litigation or restructuring can also temporarily affect margins.

• Why is monitoring profit margins important for a business?

  Monitoring profit margins helps businesses assess their financial health, make informed strategic decisions, and remain competitive in their industry. It also provides insights into operational efficiency and pricing effectiveness.

• How can a company improve its profit margins?

  Companies can enhance profit margins by increasing revenue through sales growth or price adjustments, reducing costs via efficient operations, and optimizing their product or service mix to focus on higher-margin offerings.