Profit margin , also known as return on sales is the ratio of company’s net income divided by the amount of net sales. This ratio is usually expressed as a percentage and is one of the important profitability ratios. It simply indicates for each dollar revenue, how many cents of profit the company is able to generate.
It is a great way to monitor your company’s performance. Therefore, the higher the ratio, the more money you have on hand to reinvest into the company, expand, or build your cash reserves.
How To Calculate Profit Margin?
In order to calculate your return on sales, you’ll need to know your net income and net sales. Net income is calculated by subtracting business expenses and any deductions your business is eligible for from gross income. Expenses should include anything your business spends money on, including taxes, rent, production costs, and salaries. Net sales is the amount of total sales less returns, allowances and discounts. Then, to get your profit margin, simply divide net income by net sales.
Profit Margin Formula = Net Income/Revenue (Net Sales)
Imagine your company brought in ₹100,000 one month and your total expenses were ₹60,000. To get your net income, subtract ₹60,000 from ₹100,000 to get ₹40,000. Then, divide your net income of ₹40,000 by total revenue of ₹100,000 for a profit margin of 0.4, or 40%.
Factors Affecting Profit Margin
Many factors affect your profit margin, including:
- Sales volume
- Customer buying behavior
- Prices you set for your products
- Costs of raw materials and equipment
- Marketing strategies
- Effectiveness of your managers
- Overhead costs, including rent and utilities
A change in one of these factors can impact your profit margin, and some have a direct relationship. When the cost of raw materials drops, your profit margin rises. Others, like management effectiveness, are harder to pin down because they depend on human interaction. If you have a fantastic manager who motivates and educates your sales staff, your sales and profit margin might rise.
What Can You Do To Increase Profit Margin?
It’s normal for new companies to come in below their ideal profit margin, especially in the first few years. There are several things you can do to increase your return on sales:
- Raise prices on your best-selling items
- Cut out low-performing products
- Eliminate wasted services and unnecessary costs
- Streamline your production process to save time
- Keep customers happy to increase repeat business
- Try up selling or new marketing campaigns to increase sales
As your business grows, your profit margin offers a great way to track your progress. Hence, by calculating it frequently, you can find the balance of sales and costs that maximize your profits.