The operating efficiency of a company can be expressed in terms of net profit margin. Net profit margin describes the company’s ability to earn a net income from sales. In other words, the net profit margin tells you how much profit a company makes for every $1 it generates in revenue. Net profit margins vary by industry, but, all else being equal, the higher a company’s profit margin compared to its competitors, the better.
In some cases, lower net profit margins represent a pricing strategy. Some businesses, especially retailers, may be known for their low-cost, high-volume approach. In other cases, a low net profit margin may represent a price war that is lowering profits. To evaluate the net profit margin of a company, consider the nature of the industry. A publishing company might have a 10–20 percent profit margin, while a supermarket might have a 2 percent profit margin.
The net profit margin is calculated by dividing the net income by net sales. For example, a company that has a net income of $33,000 and net sales of $960,000 would have a net profit margin of 3.4 percent.
Here’s another example. In 2018, a fictitious company Black Water Manufacturing sold 100,000 widgets for $5 each, with a COGS (cost of goods sold) of $2 each. It had $150,000 in operating expenses and paid $52,500 in taxes. What is the net profit margin?
First you need to find the revenue or total sales. If Black Water sold 100,000 widgets at $5 each, it generated a total of $500,000 in revenue. The company’s cost of goods sold was $2 per widget; 100,000 widgets at $2 each equals $200,000 in costs. Thus you get a gross profit of $300,000 ($500k revenue – $200k COGS). Subtracting $150,000 in operating expenses from the $300,000 gross profit leaves you with $150,000 income before taxes.
Subtract the tax bill of $52,500, and you’re left with a net profit of $97,500.
Plug this information into the formula:
Net Profit Margin = Net Profit ÷ Revenue
= $97,500 ÷ $500,000
= 0.195 (or 19.5%)
Keep in mind that when you perform this calculation on an actual income statement, you will already have all of the variables calculated for you; your only job is to plug them into the formula.