Concepts Behind Profit Margin

Profit Margin Ratio, as the name reflects shows the extent of Profit Margin in the revenue earned. Profit Margin means the amount earned by an organization over and above the Cost of the goods sold.

It is a type of Profitability ratio that is used to measure the amount of profit percent in each good sold. It is also used to show the classification of Expenses and Profit in the amount of Sales or revenue. This ratio is made for the purpose of the users of financial information to show the profit making capacity of the business and the efficiency of the management in cutting down expenses and increasing the profit. This is also measured so that it can show whether a product or a good is feasible to produce or if it requires some sort of cost cutting in order to maintain the profit margin.

Profit Margin Ratio is also used to compare the Profit Margins between different goods and between different periods of time during the accounting year in order to establish cost control, cost management and cost reduction if required in order to keep the Profit Margin Ratio intact.

Every business requires profit. Sometimes, in order to increase the revenue the management tries to reduce the price of the goods which reduces the profit margin. This should go hand in hand with the increase in the volume of sales in order to maintain or increase profits.

The investors of a company use the Profit Margin Ratio to see how well the company allocates its expenses and keeps the profit margin in place. At the same time, creditors see how well the business is doing to see the credibility of the business.

Calculation of the Profit Margin Ratio

Profit Margin Ratio = Net Profit/Total Revenue

Where, Net Profit=Total Revenue-Total Expenses.

It can also be calculated as follows:

Profit Margin Ratio=100-Total Expenses Ratio.

A high profit margin is good and required to attract investors and to sustain growth of an organization. However, a very high Profit Margin Ratio also indicates that a company is charging its customers much more than what their cost is and reflects badly on the company's reputation. Thus, there has to be balance in the ratio. It cannot be too high in order to maintain consumer confidence and it cannot be too low in order to maintain investor and creditor confidence.

The ratio is also used by the companies to compare their present performance with their past performance in respect to cost management and profit management. It shows how well the firm was doing earlier and how well it is doing now. It is used for budgetary controls and serves as a benchmark to determine profitability from its regular operations as sales is what drives an organization to success. In case of crisis, a company can change its Profit Margins to ensure their sales go unhindered by increase in raw material prices.

Difficulties Encountered In Profit Margin

Calculation of Profit Margin Ratio is relatively easier as the problems usually have all the key information. It can still be difficult to ascertain the amount to consider and also the nature of the transactions. The most difficult is the analysis of the ratio.

The ratio is usually calculated in relation to either the past ratios or in relation to ratios of similar companies and competitors. This increases the amount of calculation. Comparison of different ratios requires analysis of individual ratios and then analysis with the other ratios. Analysis involves many factors apart from the value of the ratio as well. To take all this into consideration, it becomes slightly difficult for the students. The problems get complicated and analysis becomes even more difficult due to which a lot of time and effort is utilized for solving Profit Margin Ratio problems.

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