Profit Margin Variance

This profitability ratio is based on the sales of the company. It depicts the relationship between profits and sales of the company. Profits may be gross profits or net profits. Consequently, there are two types of profit margin ratios: Gross Profit margin and Net Profit margin.

Gross Profit Margin

This a financial ratio used to assess the profitability of the company’s core activities. The ratio is computed as:

Gross Profit
Revenue

Where:
Gross profit = Revenue – Cost of Goods Sold

It is a measure to assess the availability of the portion of revenue that is left after paying for the goods that were sold. The available portion is used to fund other operating expenses including fixed costs and provide a return to the owners of the business.

Higher the gross profit ratio, the better it is as it implies that the cost of production of the company is relatively low or that the company is able to realize higher sales price for its goods and services. A low margin may indicate that the company has a very high production cost for its goods and services or its sale price is very low. An analysis of factors responsible for low margin must be carried out to ensure correction and sustenance of the business.

Example:

If the sales of a company amount to \$2,757,326 and its cost of sales is \$1,232,964, the gross profit margin would be:

\$2,757,326 - \$1,232,964
\$2,757,326

=> 55.28%

Net Profit Margin

This ratio shows the net profits earned as a percentage of net sales. The net profits belong to the shareholders (both equity and preference) and the ratio indicates the percentage of sales left for them after meeting all expenses and taxes. The ratio is computed as:

Net Profit
Revenue

Where:
Net profit = Revenue – Cost of Goods Sold – Operating Expenses – Interest and Taxes

The ratio indicates the efficiency of the management in the production, administration, selling, financing, pricing, and tax management areas of operations and its ability to leave a reasonable margin for the owners of the company. A high net profit margin is always desirable as compared to a lower margin as it ensures adequate return to the owners of the company and also enables it to withstand any adverse economic conditions.

Gross profit margin and net profit margin must be jointly analyzed as the two ratios may show different trends. This will enable the management to better assess the reasons for the net result and provide a basis for any improvements in the production or operations areas of business.

Example:

If the sales of a company amount to \$2,757,326 and its net income after taxes amount to \$232,964, the net profit margin would be:

\$232,964
\$2,757,326

=> 8.45%

 Operating Profit margin = EBIT x 100 Sales Pre-tax profit ratio = EBT x 100 Sales (EBT = Earnings before tax)

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