What Is Margin?
In business and finance, margin (shortened from ‘profit margin’) refers to the difference between the revenue generated by a business and the costs incurred to produce it. Calculating and analyzing margins is a key way for companies to assess their profitability. It is also used to define a type of strategy in the investment world called margin trading where a trader borrows money to invest in stocks or other assets.
How Does Margin Work?
Companies generate margins when they are able to sell products or services at a price that exceeds the production costs. The greater the margin, the more profit the company retains per unit sold after covering all associated expenses.
There are various important types of margins in business:
- Gross margin: Revenue minus direct production costs. This is the most basic measure of profitability.
- Operating margin: Revenue minus all operating expenses including salaries, rent, utilities, etc. This margin represents the profit obtained from the business’s core operations.
- Net margin: Revenue minus all direct and indirect expenses. This metric indicates how profitable the company’s business model as a whole is.
A company’s management team closely monitors margins to gauge financial performance. Declining margins over time can signal problems with profitability and lead to corrective action. Companies also commonly analyze margins by product line or business segment.
Example of Profit Margin Calculation
Let’s say a company has the following financials for the year:
- Revenue: $1,000,000
- Cost of goods sold: $600,000
- Operating expenses: $200,000
- Interest expense: $50,000
- Taxes: $100,000
The company’s gross margin would be calculated as:
($1,000,000 – $600,000)
Gross margin: $400,000
The company’s operating margin would be:
($1,000,000 – $600,000 – $200,000)
Operating margin: $200,000
Finally, the company’s net margin would be:
($1,000,000 – $600,000 – $200,000 – $50,000 – $100,000)
Net margin: $50,000
This example illustrates how gross, operating, and net profit margins are calculated by using a company’s financial statements. The margins progressively account for more expenses to show profitability at different stages.