What is the Importance of Profit Margin?

Malcolm Tatum

"Profit margin" is a term that relates to the amount of returns or profit a company generates as the result of its operational efforts. A basic formula for identifying this type of figure is to divide the amount of generated profit left after settling taxes by the revenue. Calculating the margin is important for several reasons, such as providing the company with a means of measuring its success, making it easier to determine how to allocate the profits in the upcoming year, and identifying when steps must be taken to increase profits so that a more desirable margin is generated in the upcoming fiscal year.

Calculating a profit margin measures the success of a company.
Calculating a profit margin measures the success of a company.

As a means of measuring the success of a company from one year to the next, the profit margin makes it possible to determine if the company has gained or lost ground in comparison to past periods. This often provides some insight into how well a company has weathered a difficult economic period, or managed to withstand new competition in the marketplace. If the company has managed to at least maintain the same margin of profit from one year to the next, in spite of adverse conditions, this is an indicator that the company is performing well and is financially stable. Should the calculation indicate the company has lost ground, this can be the wakeup call that leads to reassessing the operation and finding ways to trim costs in order to improve the margin during the upcoming year.

The amount of profit margin that is realized for a specific operational year also sets the stage for deciding if and how to fund projects during the upcoming year. A relatively low profit margin may indicate that launching a new project should be delayed until other operations are stabilized. Higher profit margins may mean that the company can reasonably afford to initiate several projects that could yield additional profits over time, simply by using profits earned in the past. When this is the case, the profit margin from the previous year is allocated so that some of the money goes back into the core operation, some into investments, and the remainder into the projects that will be launched in the upcoming year.

As part of the evaluation of the profit margin, the company may see this figure as an indication that steps need to be taken to cut expenses when and as possible. This may lead to reworking the manufacturing process to reduce waste of raw materials, or redefine job positions so that labor costs are minimized. The changes may also include reviewing costs for materials and other supplies that go into the production process, seeking better pricing from vendors or possibly negotiating better pricing with new vendors. Assessing the profit margin can help a company understand when the current operational structure is working within acceptable parameters, and when there is a need to make changes that ultimately result in a stronger company.

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