What Could Cause an Increase in Profit Margin?
Profit margin is, at its core, a simple equation. Expressed as a ratio, profit margin subtracts the cost of expenses from total sales revenues, then compares this result to the same sales total. Therefore, any change that increases sales or decreases expenses results in an increased profit margin. Perhaps the most used accounting tool to analyze profit margin is the income statement.
Calculating profit margin requires an analysis of both revenues and expenses, information you'll find in the common accounting tool called the income statement. Covering a defined period, typically a week, month, quarter or year, depending on the business and intended recipient, the income statement provides both direct and deductive data that’s valuable when determining the factors that can increase profit margin. However, the standard format for an income statement usually includes two profit values, gross and net profit.
The simplest calculation of profit subtracts the cost of goods sold from sales revenues for a product or service. This is called the gross profit, because it doesn’t consider revenues from non-sales sources, fixed expenses – also called overhead – or one-time costs. Typically, this is the upper section of the income statement, reflecting core operations performance.
When additional revenues and expenses are added in, usually in the bottom half, the calculation determines net profit. This includes all aspects of the company’s financial performance.
When sales increase, profit margin potentially increases, if the cost of goods sold remains at a constant percentage of sales. Raising the price per unit while cost of goods stays constant produces the biggest profit margin gains.
Selling more units may have a similar effect. If it costs more per unit to acquire raw materials, however, the extra sales may not create a profit margin increase. The biggest gains are made when fixed expenses remain at the same dollar amount, a condition that adds a dollar-for-dollar increase to the net profit margin.
If the company has revenue from activities not related to core business, such as investment income, for example, this revenue adds to the profit margin. Again, it's usually on a dollar-for-dollar basis, with increases reflected on the bottom line and in the profit margin.
Reducing the cost of goods sold improves gross profit margin, if sales revenue remains consistent. Likewise, decreases in fixed expenses add to bottom-line profit and increased net profit margin. A company facing profitability challenges may look at reducing administrative expenses, such as accounting or human resources staff, because these departments typically don’t add revenue to the business.