Profit margins can vary by sector and industry, but the outcome is the same. The higher a firm’s net profit margin is compared to its competitors, the better for the business.
Exceptions to the Rule
There are some exceptions to the net profit margin rule. To dig deep into why, this would require getting into a complex analysis of the DuPont Return on Equity formula. The short and sweet version follows. A business that relies on sales can make an additional absolute net profit by lowering its net profit margin and driving sales up as people buy goods from its stores. Dillard’s, a well-known department store, has used this approach in the past. It had a lower net profit margin of 1.77% as of January 31, 2020. At the time, this was lower than other retailers such as Walmart, which earned 2.84% as of the same date. There’s a fixed danger in this approach when dealing with high-end brands. Forcing prices lower to drive sales is often called “going downstream.” Business can begin to suffer when a retailer has lost status in the mind of the public.
How to Find the Net Profit Margin
Conventional wisdom tells investors to divide the after-tax net profit by sales to find the net profit margin from a company’s income statement. While this is standard and accepted, some people prefer to add minority interest back into the equation. This will give you an idea of how much money the company made before paying out to minority owners.
Doing the Math
Either method of calculating net profit margin is acceptable, but you should use the same math across firms to make an equal comparison. All firms should be compared on the same basis. Each calculation would work like this:
Option 1: Net income after taxes ÷ revenue = net profit margin.Option 2: Net income + minority interest + tax-adjusted interest ÷ revenue = net profit margin.
Again, lower net profit margins can equate to a pricing strategy. They don’t always mean there’s been a failure on the part of management. Some firms, especially retailers, discount hotels, and chain restaurants, are known for their low-cost, high-volume approach. In other cases, a low net profit margin might mirror a price war that’s bringing profits down. This was the case with the computer sector back in the year 2000. More people were jumping on the personal computer bandwagon, but not all were willing or able to afford the high prices. Sellers slashed prices to lure buyers in. They were even giving their products for free in exchange for advertising.
An Example of Net Profit Margin Math
In 2009, Donna Manufacturing sold 100,000 widgets for $5 each with a cost of goods sold of $2 per unit. The firm had $150,000 in operating expenses and paid $52,500 in income taxes. What is the net profit margin? Start by finding the revenue or total sales to get the answer. Donna’s had a total of $500,000 in revenue if it sold 100,000 widgets at $5 each. The company’s cost of goods sold was $2 per widget, and 100,000 widgets at $2 each equal to $200,000 in costs.
This leaves a gross profit of $300,000 ($500,000 revenue - $200,000 cost of goods sold = $300,000 gross profit).Subtracting $150,000 in operating costs from the $300,000 gross profit leaves you with $150,000 income before taxes.Subtracting the tax bill of $52,500, you are left with a net profit of $97,500.
Plugging these numbers into the net profit margin formula gives you:
$97,500 net profit ÷ $500,000 revenue = 0.195 net profit margin, or 19.5%.
Therefore, the answer is 0.195. Move the decimal, and 19.5% is the net profit margin.
