Profit margin is the percentage of sales that a business retains after all expenses have been deducted. This margin is a key indicator of the financial health of an entity. The calculation of the profit margin is sales minus total expenses, which is then divided by sales. The calculation is expressed as follows:
(Sales - Total expenses) ÷ Sales
Dividends paid out are not considered an expense, and so are not included in the profit margin formula.
For example, ABC International incurs expenses of $1,900,000 on sales of $2,000,000 in its most recent reporting period. This results in the following profit margin:
($2,000,000 Sales - $1,900,000 Expenses) ÷ $2,000,000 Sales
= 5% Profit margin
The profit margins generated by businesses within the same industry tend to be quite similar, since they all sell at roughly the same price points and have the same types and amounts of expenses. An organization can diverge from this average profit margin by emphasizing sales in specialty niches, as well as by using such restructuring techniques as outsourcing production, minimizing the investment in inventory, and shifting to a low-tax region.
A common situation is for a business to initially grow within a profitable niche, which the entity maximizes to the greatest extent possible. Management is then under investor pressure to continue growing sales, so it expands outside of its original niche, into less profitable areas. The result is an increase in sales, but a lower profit margin as the organization continues to expand.
The profit margin is one of the key performance indicators for management - to such an extent that the maintenance of a high margin is likely to form a key part of the criteria upon which bonuses are paid to managers.