When gauging the financial stability of a company, it's important to know whether or not it's making money. But that alone is not enough information to tell you how the business is doing. A company can generate a high volume of sales, while not being profitable. Profitability reveals how much of every dollar goes into generating sales and how much can go into the pockets of the owners. If a business has $1 million in sales, but only 10 percent of that revenue ends up in the pockets of the owners, it is not as profitable as the $100,000 business that puts 75 cents of every dollar in the owners' pockets. Profit margin ratios, such as gross profit margin and net profit margin, enable you to analyze profitability at different stages of a firm's operations.
Cost of Sales
Gross profit margin reveals how efficiently a company uses labor and raw materials. It is a production stage profitability analysis that focuses on one phase of operations, rather than the business as a whole. Gross profit margin subtracts the cost of creating the goods being sold from the revenue generated from the sale of those goods. What is left over is the very basic answer to how much of a dollar goes to producing the goods or services for sale.
Cost of Business Operations
Unlike gross profit margin, net profit margin looks at profitability after the expenses associated with all phases of business operations. It is a bottom-line analysis that not only takes into account the cost to produce the goods for sale, but also the costs of doing business. To calculate net profit margin, you deduct taxes and indirect costs from sales, such as for administration and other non-production costs.
Gross profit margin allows business managers to track and control production costs. By isolating this phase, managers can identify when increases in labor costs or the costs of raw materials will affect profitability. It allows the managers to develop a price strategy for the company's goods that is tied to the actual cost of production, plus a targeted profit margin. Gross profit margin takes the profitability analysis down to the basic factors needed to stay in business. The net profit margin contains a lot of non-production expenses that are variable and can be reduced or eliminated to improve profitability, such as administration and marketing.
Gross and net profit margin ratios are used to indicate different aspects of a company's financial health. A high gross profit margin, for example, indicates that a company has extra funds that could be used for things like research and development. A company with a gross profit margin that has been decreasing for years typically has a significant labor or supply problem that could threaten the future stability of the company. Meanwhile, the net profit margin allows companies in the same industry to compare standards of operation. A ratio analysis puts companies of all sizes on a level playing field so that industry norms can be established.
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