Profit Margins

A profit margin is a profit figure from the income statement expressed as a percentage of revenue, rather than as a raw dollar amount. The three most common are:

• Gross margin — revenue minus the direct cost of what was sold, divided by revenue
• Operating margin — profit after also subtracting the everyday costs of running the business (rent, wages, marketing), divided by revenue
• Net margin — profit after everything, including interest and taxes, divided by revenue — the bottom-line percentage

A company that earns $1 million in profit sounds far more successful than one earning $10,000 — but that comparison is meaningless without knowing how much revenue each company needed to generate that profit. A business earning $1 million in profit on $100 million of revenue is converting only 1% of every sales dollar into profit; a business earning $10,000 in profit on $50,000 of revenue is converting 20% of every dollar into profit — a far more efficient business, despite the much smaller dollar figures. Raw profit dollars conflate a business's efficiency with its sheer size.

Profit margins fix this by expressing profit as a percentage of revenue instead of a dollar amount, which cancels out the effect of size and leaves a number that reflects how efficiently a business converts sales into profit. This is what makes it possible to meaningfully compare a giant company to a tiny one, or to track whether the same business is becoming more or less efficient over time, even as its revenue grows or shrinks.

Margins are calculated at different stages of the income statement because each one isolates a different source of profit or loss. Gross margin isolates how efficiently a business produces or delivers what it sells, before any of the broader costs of running the business are considered. Operating margin adds in the everyday cost of actually running the business, showing how the core business performs before financing and tax effects. Net margin includes everything, down to the bottom line. Watching all three separately can reveal, for example, that a business's product itself is highly profitable (a strong gross margin) even while poor cost control elsewhere in the business drags down its net margin.

Gross margin     = (Revenue − Cost of goods sold) / Revenue
Operating margin = Operating income / Revenue
Net margin       = Net income / Revenue

Using Maria's bakery figures from The Income Statement:

Revenue:                        $20,000
− Cost of goods sold:             $6,000
= Gross profit:                  $14,000   → Gross margin: 70%

− Operating expenses:            $10,000
= Operating income:                $4,000  → Operating margin: 20%

(no separate interest or tax in this simplified example)
= Net income:                      $4,000  → Net margin: 20%

The gap between the 70% gross margin and the 20% operating margin shows exactly how much of each sales dollar gets absorbed by the everyday cost of running the bakery, after the direct cost of ingredients is already accounted for.