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What is a High Profit Margin?

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  • Written By: Toni Henthorn
  • Edited By: W. Everett
  • Last Modified Date: 28 October 2016
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A profit margin, also called a net income margin, is a financial ratio used to evaluate a company’s profitability. When a company has a high profit margin, it means that a high percentage of each dollar generated by the company in revenue is actual profit. For example, a profit margin of 19 percent means that 19 cents out of every dollar of revenue is profit for the company. In order to create a high profit margin, companies must actively curtail costs, strategically price their products and services, and fend off competition. The percentage constituting a high profit margin varies between industries and sectors, limiting the use of the profit margin to internal comparison or comparison between companies in the same industry.

Accountants and business managers calculate the profit margin using financial information pertaining to a limited period. First, the costs of sales, operating costs, and overheads are subtracted from the total revenue. Second, any interest payable and refunds are subtracted. The resulting value is the net profit. An accountant can then derive the profit margin by dividing the net profit by the total revenue and multiplying the value by 100 to obtain a percentage.

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The pricing strategy of a company can be a significant contributor to a high profit margin. In choosing the right price for a product or service, the company must, first and foremost, place a high enough price to recover all costs. A price, however, must not be set so high that it turns off customers. Other considerations in pricing include the product demand, the product quality, the advertising and promotional plans for the product, and the distribution of the product. The boundaries of a well-determined price are the price floor, at which the company experiences a loss with the sale of the product, and the price ceiling, at which customers refuse to buy the product.

Another ratio used to evaluate company productivity is the gross profit margin. The top number of this ratio is gross profit, defined as the total revenues minus the costs of goods sold. Like the profit margin, the bottom of the ratio is the total revenues amount. Because the gross profit margin should remain relatively stable over time, substantial fluctuations are red flags for possible accounting abnormalities or fraudulent activity. When obtained using the gross margin calculation, a high profit margin points to an organization that should be able to make a reasonable net income, with money left over for dividends, as long as the company controls its costs.

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summing
Post 5

There is a scenario that my dad likes to remind me of over and over. He says "Think about fountain drinks. The cup, straw, lid, soda syrup and carbonated water together don't cost more than a few cents. But the store where you buy the soda charges you at least 50 cents probably more. That is at least a one thousand percent profit margin."

He like to say this as an example of how much money big companies make and how often you get tricked when you pay for things. He is kind of a cynic. He doesn't think anything is worth as much as people think it is. With the soda fountain analogy I have to agree with him. On other things it is a little harder.

bear78
Post 4

@fify-- Hi, it's actually very simple. The gross profit margin is the sale price minus the actual cost of the sale. So if you sold a product for $10 and it cost you $5 to produce it, the gross profit margin is $5.

The net income margin, which is the profit margin we're talking about here, is your profit minus all of the expenses. So it's the profit of all your sales minus all of your expenses in the company.

And the operating profit margin is the net income divided by the sales. So it's how much profit you're making per sale.

If you are a shareholder, you would definitely want to know about the net income/profit margin, because this is what the shareholders will get a piece of. The other profit margins are just additional details about how the company is doing.

fify
Post 3

Thank you for the article, it's helping me a lot with my assignment! I do have a couple of questions though.

How is a high profit margin different than a high operating or gross profit margin?

And which profit margin do shareholders in a company generally care about the most? I mean, if I am a shareholder in a company, which profit margin do I want to know about?

ddljohn
Post 2

I hear this term from my uncle all the time. Recently, he started a small business for antique woodwork. He invested a lot of money in various equipment and does all of the woodwork himself. He's actually been enjoying a high profit margin from the beginning, but almost lost the business when one of the equipment he uses regularly broke down. The guarantee for the equipment was over and it costs a considerable amount of money so it was not easy for him to replace it.

Thankfully, things worked out and he's doing much better. He has gotten better equipment and regularly gets them checked out to avoid any problems in the future. I learned from his experience though that even a high profit margin may not save a business when there are huge unexpected costs. Small businesses are especially at risk for this.

cafe41
Post 1

I remember when I used to work in a department store, the items with the highest profit margins were the mattresses. The mattresses were marked up so high that it was easy to negotiate a better deal with the salesman.

This is why you always see these sales that offer 50% off and you wonder how they could afford to do that so often. The profit margin formula for most mattresses in the stores equates to about a 90% markup. This is where the real money is made in department stores.

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