Net Profit Margin

What is net profit margin?

The net profit margin, sometimes called net margin, is a financial ratio that shows how much revenue a company takes as actual profit. It is one of the primary metrics used to determine a company’s overall health or performance. A business with a high net profit margin is keeping costs under control and has a successful pricing model. 

A company can use its net profit margin to compare its success with that of similar companies in the same industry. Investors often use this metric to find businesses they should invest in.

Accounting software can help an organization measure net profit margin at regular intervals and track it over time. Such software can also generate reports on this metric and other key indicators of financial health.

Calculation of net profit margin

To determine the net margin, an organization must divide its net income (earnings minus expenses) by its total revenue (earnings). The result can be expressed as a decimal but is usually reported as a percentage. To turn the decimal into a percentage, the result is then multiplied by 100.

For example, say a company has a gross income of $75,000 and its total costs are $22,000. The net income (subtracting one from the other) would be $53,000. $53,000 (net) divided by $75,000 (gross) is .7067.

This figure is then multiplied by 100. The company has a net profit margin of 70.67%.

Benefits of net profit margin

The net profit margin is a key performance indicator (KPI) for small and large companies alike. Formulating and tracking this metric is beneficial because it:

• Reveals the impact of costs on a company’s final profits because the net profit margin will be lower if costs are high.
• Guides pricing strategy because a high net profit margin may indicate on-point pricing while a low one may show a need for change.
• Helps make comparisons between two companies with varying revenue within the same industry.

How to increase net profit margin

When looking to increase the net profit margin, a company may lower costs or attempt to increase revenue from its products and services. Here are a few specific ways a company can improve this metric:

• Raise (or lower) prices. If a company has a loyal customer base, a slight increase in pricing might be accepted – and if rates haven’t been raised in a while, a price increase might even be expected. Conversely, some businesses might consider lowering prices, either as a temporary sale or as a more permanent measure. Lowering prices could increase the volume of units sold, increasing the overall revenue. 
• Reduce operating costs. Take a look at the costs involved at each step of the production process. Sometimes it is possible to buy certain products in bulk or negotiate a lower rate with vendors. Remember that a company can also save money when it uses software to automate administrative tasks.
• Lower labor costs. The cost of labor can add up fast. Look closely at the money spent on paying employees overtime, and consider whether work can be rescheduled or distributed to avoid it. Also, consider outsourcing to contractors or freelancers instead of bringing on another full-time employee. Additionally, consider creating a labor forecasting strategy. 
• Cut clients, products, or services. When possible, analyze the net profit margins of specific offerings. Consider cutting low-performing products to invest time and energy on high-performing aspects of the business instead.
• Avoid waste. In product-based businesses, check for material losses – waste, scrap, and spoilage. Then consider how to troubleshoot. For example, forecasting or demand planning can lead to more accurate ordering and fewer goods spoiling on the shelves. 

Net profit margin vs. gross profit margin

Both net profit margin and gross profit margin are metrics of a company’s success and profitability. Sometimes individuals confuse these two terms, but they have different meanings.

Net profit margin is a ratio expressing the amount of revenue taken as profit. To arrive at the top number of the ratio (net profit), all expenses are subtracted from the total revenue.

On the other hand, gross profit margin is the ratio of the total revenue remaining after accounting for the money a company spent on the cost of goods sold (COGS). COGS includes raw materials and labor, but does not include overhead costs.