A high profit margin on sales is not always a blessing unless it is related to reasonably large volume of sales. The fact is that a low-profit margin on sales is better compared to a higher-margin if the former is accompanied by a rapid turnover. Ultimately it is a return on profitability.

Size of profit margin depends upon ability to control operating costs and suitable pricing policy of a company management.

        Profit margin is a measure of overall profitability. The more commonly used accounting forms of profit are gross profit in origin and net profit margin. Profit margin figures can be best evaluated by expressing them as % of net sales (sales minus sales return, discounts and return etc.) A company should be able to earn adequate profit on each rupee of sales, otherwise it would be difficult for it to cover its fixed costs and fixed charges on debt and to give a reasonable return to shareholders.

1.       Gross Profit Margin :

It is the excess of selling price or sale proceeds over the cost of goods sold and it provides the balance for operating expenses, income tax and return on capital employed. It indicates the efficiency of operation and the price policy of the management. Gross profit ratio is an indication of the extent of average mark up on cost of goods. It is primarily test of efficiency of purchase and sales management. Deducting cost of goods sold from value of net sales has arrived at the Gross profit margin of the company.

2.       Net Profit Margin :

Net profit margin establishes a relationship between Net Profit and sales. Net profit may be analyzed on two accounts, first net profit before tax and second net profit after tax. Net profit margin indicates the efficiency of management in administrating, manufacturing and selling products. It is overall measure of a company's ability to turn each rupee of sales into Net profit. Thus if the Net profit margin is inadequate the company will fail to achieve a satisfactory return on owner's equity. Net profit margin differ from the operating profit to sales ratio as it is computed after adding non-operating surplus.

3.      Operating Profit Margin :

Operating profit margin is the difference of Net sales and total operating cost. Operating profit margin varies with the disproportionate variation in sales revenue in comparison to costs and vice-versa. When costs remain the same, it is for the management to mark up or down as the case may be.

On the contrary, price per unit remaining the same if the management succeeds in bringing about a down variation in all or same of the components of the cost structure the result will be an upward change in the margin of profit on sales.

Thus Operating profit margin can be increased either by marking up prices or by reduction in the cost or partly by both.

Thus :

   

4.     Depreciation :

In accounting terminology the word "depreciation" is used for the procedure used to allocate the cost of long term tangible assets to the accounting periods which comprise its useful life. All fixed-assets have a limited period of useful life except land. It is a process of allocation and not of valuation. It is a systematic procedure for allocating the cost of long lived assets over its useful life. It is important for determining the true profit to retained funds in business so that assets can be replaced at proper time for presenting a true balance sheet and as a tax shield.

Under this head, we calculate two types of Ratio :

a)       Depreciation to Gross Block Ratio.

b)      Depreciation to Net Sales Ratio.

(A)     Depreciation to Gross Block Ratio :

Here, Gross block means the total fixed assets of company before depreciation.

This ratio is calculated as under :

(B)     Depreciation to Net Sales Ratio :

This ratio may be calculated as follow :

5.      Power & Fuel Ratio :

Power & Fuel is an essential requirement, not only its adequate supply but continuous availability.

Formula :

6.       Raw Material Consumed Ratio :

The modified raw is used in a broader sense, as this category includes all the materials used in production whether in a natural state or changed by previous processing. In other words, raw materials are the materials used in manufacturing process. These are two types of ratio relating to raw material :

a)  Ratio of Raw Material consumed to Net Sales.

b)  Ratio of Raw Material consumed to cost of goods sold.

(A)     Ratio of Raw Material consumed to Net Sales :

This ratio may be calculated by the following formula :

       

(B)     Ratio of Raw Material consumed to cost of goods sold :

            This ratio can be calculated by the following formula :

               

7.  Manufacturing, Administration & Selling Expenses to Sales :

(A)     Manufacturing Expenses :

In manufacturing a company's prices as well as its profit margin are determined to a large extent by its manufacturing expenses because in most industries manufacturing expenses are primary-factors in production.

Manufacturing expenses include power and fuel, wages and salaries, bonus, gratuity, P.F. and other allowances, welfare expenses, store, spares and packing materials consumed, depreciation, excise, royalty and other duties, insurance, factory license fees, repairs & maintenance etc.

Formula :    

 

(B)    Selling, Distribution & Administrative Expenses to Sales :

In an enterprise, besides cost of production, certain other expenses which indirectly contribute to production, have to be incurred. Selling, Distribution & Administration Expenses includes commission to selling agents, brokerage & discount, freight, handling & other expenses, Advertisements & Publicity, Insurance, Rent (including Lease Rent), Rent & Taxes, Stationery, Printing, postage & telephone expenses, traveling conveyance, legal & professional charges, bad & doubtful debts, research cont. donations, director's fees & com. Etc.

8. Operating Profit After Interest but Before Tax :

Some companies have been playing corporation tax on the profits earned by them from year to year, whereas some other were exempt from it either because of losses or because of their profits being exempted from tax, but the case of cos. Paying pre-tax and post tax profits is different.

 

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