Profit margin is a percentage measurement of profit that expresses the amount a company earns per dollar of sales. Obviously, if a company makes more money per sale, it has a higher profit margin.
The gross profit margin shows total revenue minus the cost of goods (the amount it cost the company to produce the goods or services that it sold, commonly referred to as cost of goods sold, or COGS). The calculation to arrive at gross profit margin is:
Gross profit margin = (Revenue – Cost of Goods) ÷ Revenue = Gross Profit ÷ Revenue
For the year ended December 31, 2016, Dunkin’ Brands Group, Inc. (DNKN), the holding company of Dunkin’ Donuts and Baskin-Robbins, reported a total revenue of $828.89 million and COGS of $148.61 million. DNKN’s gross profit margin is:
($828.89 – $148.61) ÷ $828.89 = 82.07%
This means that for every dollar DNKN generates in sales, $0.18 is used to cover the cost of inventory, and $0.82 is available to cover basic operating expenses. A higher ratio is usually preferred as this would indicate that the company is selling inventory for a higher profit. Gross profit margin provides a general indication of a company’s profitability, but it is not a precise indication.
The net profit margin is a more accurate measure of a company’s profitability, as it reveals the percentage of revenue that actually reflects a company’s profit per dollar of sales. Net profitability is an important distinction, since increases in revenue do not necessarily translate into actual increased profitability. Net profit is the gross profit (revenue minus cost of goods) minus operating expenses and all other expenses, such as taxes and interest paid on debt. The formula for net profit margin is as follows:
Net profit margin = (revenue – cost of goods – operating expenses – other expenses – interest – taxes) ÷ revenue = Net Income ÷ Revenue
DNKN’s net profit margin for the fiscal year ended December 31, 2016 is:
$195.58 million ÷ $828.89 = 23.60%
A 23.60% net profit margin indicates that for every dollar generated by DNKN in sales, the company keeps $0.24 as profit. It is also possible for a company to have a negative net profit margin. A negative net profit margin occurs when a company makes a loss for the quarter or year and could be a temporary issue for the company. Reasons for losses could be increases in the cost of labor and raw materials, recessionary periods, and introduction of disruptive technological tools that could affect the company’s bottom line.
Examining its net profit margin can help a company gain a much clearer picture of its overall expenses compared to revenue. It is often much easier for a company to increase its profitability by reducing costs than by increasing sales, especially if the company operates in a very competitive market.