Profit is one of the most carefully monitored numbers on any company’s financial statement. After all, a healthy company is a profitable one.
Yet for all the attention profit margins receive, they are rarely analyzed as deeply as they could be. The fact is that profit margin, whether gross, operating, or net, can yield valuable insight into the efficiency of your company and help you take greater advantage of strategic opportunities even as you avoid potential pitfalls.
Here’s how to examine these measures beyond their Accounting 101 definitions:
- Gross Profit Margin measures how well a company controls the cost of producing and delivering its products. The key to monitoring gross profit is making sure you’ve properly allocated fixed and variable costs. This is easier said than done, and there are a number of approaches, each with advantages and disadvantages. One example would be pooling overhead costs and assigning a per-unit burden to establish margins on individual products.
“With that system, it’s easy to overstate or understate overhead if production is higher or lower than expected,” explains Marilyn Landis of Pittsburgh-based consultancy Basic Business Concepts. What’s more, the degree of baseline fixed costs can strongly influence per-unit profitability. The classic example of fixed-cost issues is the airline industry: An empty plane costs nearly as much to fly as a full one, so even selling last-minute seats at a “loss” will add to the bottom line.
- Operating Profit Margin. The operating profit margin ratio is a measure of overall operating efficiency, incorporating all of the expenses of daily business activity. You can begin here to drill down into how efficiently a company is managed outside the revenue-production process. The key, again, is effective cost accounting. Just as it is crucial to know the per-unit cost of a product, so too should managers be aware of the cost of internal services such as recruiting or facilities maintenance.
“A good example is HR,” Landis explains. “If you know the cost of delivering a service, say by the hour or by the hire, you can allocate those costs to the departments availing themselves of that service.” For instance, one department may be allocated a higher HR expense line item (and thus lower margin) because of high turnover—information that would otherwise be buried in overhead. Similarly, sales and marketing costs should be assigned to specific customers or segments in order to gauge profitability.
- Follow the money. Once you’ve allocated costs across the board, it will be easier to track down the source of margin fluctuations. If profit margin declines, you can drill down to discover the issue. You might begin by looking at divisional, product, or customer margins to narrow your focus.
“The first question is, are your sales down?” Landis says. If so, then you’ll either have to rebuild them to grow into your overhead (in the form of underutilized capacity or managerial payroll) or consider cutting those costs. If sales are flat or growing, then the issue lies in your cost structure itself. “First, look at your variable expenses. Whether sales are up or down, they should run at a consistent percentage of sales. If not, you’ll need to drill down further to find the anomaly,” she explains. “Maybe your raw materials went up. Can you increase your pricing to cover that, or are there efficiencies or substitutions you can make to get the cost of goods sold (COGS) back in line?”
The next item to look at is overhead. “The biggest issue I find with clients is overhead creep,” Landis says. “Take a look at your compensation structure. Are you giving raises that your sales can’t support? Are your bonuses properly tied to profit margin—or are you rewarding some other metric that doesn’t correlate well?”
Remember that like any financial ratio, profit margins are most useful as performance indicators when measured over time to uncover trends. Doing so will turn your attention away from where you’ve been — and toward where you’re headed.
