Profit Margins – Everything you need to know
Profit margin is generally expressed by financial experts as a percentage. A lot of things can be interpreted using profit margins. Read on to know.
A simple profit margin is expressed as the ratio of profit to its sales. A high-profit margin indicates good profitability of the business. A low margin indicates that profitability is low.
The types of profit margins are as follows:
- Gross profit margin: Gross profit margin is used by manufacturing companies. It is nothing but the ratio of income to variable costs.
- Operating profit margin: It is the ratio of income to both variable and fixed costs.
- Net profit margin: It is net profit divided by net sales.
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Importance of high-profit margins:
High-profit margins are important in the following ways:
- High-profit margins help to attract more investors.
- The desire to have a good profit margin creates employment opportunities by way of outsourcing.
- It creates more generation and distribution of income and wealth. Hence economic improvement becomes possible.
You may be surprised to know that even when the sales level is high, a company can show low-profitability indications. The following may be the reasons for such a scenario:
- Low pricing:
When the level of pricing is low, the profitability will be low in spite of having huge sales.
- Increase in expenses:
When the expenses have rapidly increased, they eat up the revenue. Hence even when the sale is huge, the profitability tends to be low.
The phenomenon of having low profitability in spite of huge sales is due to profit erosion.
Ways to arrest profit erosion:
- Monitor and control wastages: In a manufacturing business, the wastage of power, raw material etc. eat the profits. So, it becomes important to eliminate wastages.
- Idle assets: Any form of unused assets like building, machinery, human capital etc. reduces profitability.
- Cost control: Cutting of production, operating and marketing costs are essential.
- Interests: When there are huge debts and when a considerable sum has to be paid as interest, profitability will be low. Hence it becomes essential to lower the borrowings by infusing more capital.
Adopting the above ways as early as possible to reduce profit erosion will save the business.