The main difference between net profit and contribution margin is that the net profit margin is a percentage that shows how much of a company’s revenues are kept as net income. It is part of the company’s income statement. On the other hand, the contribution margin ratio is the ratio of the company’s total contribution margin to its total sales revenue.
Net Profit Margins – It’s Strenght And Weaknesses
When investing in a company or running your own business, one of the most important metrics to look at is the net profit margins. When buying a stock or starting a business, one of the primary goals is to return on the investment. If you don’t know the net profit margin, then it’s likely that you won’t know if a business is making money or not.
This article will learn about the net profit margin, the formula, importance, and more.
The idea of a net profit margin is elementary to understand. This metric is useful for determining how much a business can extract profit from net sales. The formula for net profit margin goes like this :
(Net Profit / Net Sales ) X 100 = Net Profit Margin
Net Profit Margin Calculator
How is the net profit margin ratio is useful in planning business operations?
The net profit margin and contribution ratio are metrics that can give you a good picture of a company’s overall success. If a company shows a high-profit margin, it generally means maximizing the sales of its products while minimizing costs. This metric is often used for regular reporting periods like monthly, quarterly, or annually. It’s typically found in the income statement.
The net profit margin is especially a good indicator when evaluating several companies within the same sector as the cost structures, customer base, and business environment are roughly the same. Hence, if business A has a higher net profit margin than business B within the same sector, it’s safe to assume that business A is the better company.
For most mature companies and sectors, 10% and above net profit margin is considered excellent. However, the number could change drastically depending on the sector, business structure, and other factors.
How is the contribution margin ratio useful in planning business operations?
The contribution margin ratio is useful in planning business operations during target profit and break-even analysis because it can quickly estimate the effect on profits of a change in sales revenue.
Things To Consider About Net Profit Margins
Like all metrics, net profit margins has its own weakness. Therefore, you should not consider this as a “be-all and end-all” metric. In fact, it’s better that you consider it as an important piece of a puzzle. Below are a few things you should be aware of net profit margins.
* Comparability – the “acceptable” profit margins vary from one sector to another. In some sectors, low-profit margins are acceptable. A good example is grocery stores. Such establishments generally have low acceptable profit margins because the products move quickly. On the other hand, a high net profit margin is a must for sectors that carry slow-moving inventories. Otherwise, the business may risk not staying above the fixed cost and other similar expenditures.
* Leveraged Situations – another issue with net profit margin is it’s not the complete picture of a business. Leveraged situations may give you a falsely negative view of a business. If a business chooses to grow through debt financing, it’s natural for a company to pay interest fees and such. These will then bring down the net profit margin. If you blindly believe the net profit margin metric, then you run into the risk of losing a good opportunity. For example, the business could be very healthy, but it brings the net profit margin down because of the current debt financing. By the time the debt gets paid off, the business may have an above-average net profit margin.
* Non-operating Items – another weakness of the net profit margin is it only considers the sales and expenditures. There are instances that a business is showing a very high net profit margin. However, it could be due to a single event that is not part of “normal business operations.” This could be a huge but unrepeatable sales order. In such cases, you may end up being tricked that the business is very profitable when, in fact, it’s a temporary spike.
Wrapping It All Up
After this article, you need to read about the contribution margin and contribution margin ratio useful in planning business operations.
The net profit margin is expressed in terms of percentage. It’s a metric that reports the percentage of profit a company can get from net sales. The net profit margin is often a metric used to gauge a business’s health and compare it with other similar businesses. However, keep in mind that it’s only a piece of a puzzle, and there are instances that the net profit margin can be harmful if you blindly trust the metric.