The purpose of entering into business is to make a profit, so it only makes sense to keep a close eye on profitability measures.  This week we are going to touch on two such measures and they are Profit Margin and Operating Margin. 

Profit Margin is defined as Net Profits divided by Sales.  Another way to look at this measure is that it tells us how much of each dollar of sales is actually kept.  A high Profit Margin is an indication that the company is doing a good job of converting sales to bottom line earnings.  It is a measure of efficiency. If a company can generate a higher Net Profit on the same amount of sales, then they are more efficiently producing earnings.  For example, if “Company A” has a Net Profit of $20 million from $200 million of sales, then the Profit Margin would be 10%.  Let’s compare that with “Company B” that generated $30 million in Net Profit on $400 million of sales.  Even though “Company B” is generating a larger Net Profit, it is taking greater sales to do it.  “Company B” is less efficient than “Company A” and that is reflected in the Profit Margin.  “Company A” has a Profit Margin of 10% and “Company B” has a Profit Margin of 7.5%.

Operating Margin is defined as Operating Income divided by Net Sales.  Operating Income (Gross Income minus Depreciation) needs to be defined in order to arrive at Operating Margin.  Net Sales is defined as sales after returns, missing and damaged goods.  Net Sales is a metric that allows a more accurate picture of sales.  Operating Margin tells us the amount of resulting revenue after variable costs such as cost of materials and employees.  If the number is high, it is considered to be favorable.  It is best to measure the company over time against itself in quarter over quarter or year over year comparisons.  One time, nonrecurring expenses are not normally included in the Operating Margin calculation.

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