The concept of Margin and profit are related to each other. In fact, margins are a very effective tool in understanding the growth and development of any business. There are several ways to measure your company’s profits other than just looking at your bank account which, to tell the truth, doesn’t tell you much about profitability. In the following section, we will introduce the concept of margins and define several important terms that help us in understanding finance and business better. Following is a guide to help you broaden your understanding of the most common types of business costs applicable to small businesses and how they influence profit margins.
Understanding and monitoring your costs and margins is vital for any business owner and failure to get this area right can mean that whilst you may well be busy you are not converting that into profitability. In fact, many small businesses that appear to be thriving often fail because their prices are too low or their costs are too high and they can’t make a profit. You will want to avoid falling into that trap and the information here will help you to better understand costs and margins so that you can avoid pricing problems, losing money on sales, and ultimately stay in business.
The margin is the percentage of the final selling price that is profit.
A markup is the percentage of the cost price you add on to get the selling price.
Gross Profit Margin (GPM)
To calculate Gross Profit Margin (GPM), two figures from the Profit & Loss Account (Income Statement) are needed:
Sales Revenue and Gross Profit.
The formula for calculating GPM is: The answer is given as a percentage = [(Gross Profit)/(Sales Revenue)]×100
Net Profit Margin (NPM)
To calculate Net Profit Margin (NPM), two figures from the Profit & Loss Account (Income Statement) are needed:
Sales Revenue and Net Profit. The formula for calculating NPM is:
The answer is given as a percentage = [(Net Profit)/(Sales Revenue)]×100
Profit And Profit Margins
Profit may be defined as the amount of money that you retain from the sale of goods and services, after deducting all of the costs associated with the provision of those goods and services and your fixed costs. This is more commonly known as net profit.
The Profit Margin indicates the percentage profit a business makes on a sale. The Profit Margin is normally calculated as the Gross Profit, which is the excess of income over the costs (excluding payroll) directly associated with making the sale (e.g. the cost of food sales or the cost of the beverage sales).
Two terms are frequently used when discussing prices and they are markup and margin. These are different ways of calculating profit, and the difference can be confusing. A selling price with a margin of 25% results in more profit than a selling price with a markup of 25%. To understand why margins are higher, imagine an item that costs €100. If you sell it with a margin of 50% – that means fifty percent of the selling price should be profit i.e. if you sell it at €200, half the selling price is profit – margin 50%.
If you sell the same item (cost €100) with a markup of fifty percent, you add fifty percent of the cost price. Fifty percent of the cost price is fifty euro. This makes the total selling price €150. A fifty percent margin is higher than a fifty percent markup.
Improving Profit Margins
Successful businesses continuously seek ways of improving their profitability. In circumstances where we can uplift the gross profit margins, we can also uplift the overall net profit of the business. The following actions may be taken to improve profit margins:
A) Increasing prices.
B) Reducing your cost of sales through more effective purchasing (e.g. use of tendering – more than one supplier ensures competition, both for price and supply of a quality product; regular checking of suppliers prices).
C) Reducing payroll and other direct costs (are you over-staffed? – do you plan your staff requirements on the basis of known demand? If not, an opportunity exists to improve your productivity).
D) Reducing fixed and variable costs (such as insurance, fuel, electricity costs) by requesting quotations from a number of service providers, encouraging clientele to become aware and involved in good environmental practices on site (switching off lights when not required, re-using towels), raising staff awareness of company policy (e.g. switching off heating in areas of the premises not in use).
E) Maximising income from high margin products. For example, accommodation sales typically generate a higher profit margin than food and beverage sales. In circumstances where accommodation sales are low relative to other sales, there may be a substantial opportunity to increase profit through an increased level of accommodation sales.
Q 1: Mikey Winterworth owns a small business selling electronic components to other businesses. Mikey has produced the following Profit & Loss Account (Income Statement) for the last 12 months. Mikey needs help in calculating his GPM and NPM. Use the information below to help you calculate both of these ratios. Give your answers to 1 d.p.
|Sales Revenue||£73 000|
|Cost of Sales|
|Opening Stock||£8 000|
|Closing Stock||£6 750||£14 750|
|Gross Profit||£58 250|
|Net Profit||£14 500|
A) GPM: 79.8%, NPM: 19.9% B) NPM: 10.9%, GPM: 89.8% C) GPM: 69.8%, NPM: 29.9% D) N.O.T.A. (None Of The Above)
Ans: A) GPM: 79.8%, NPM: 19.9%