The net profit margin account of a company reveals the amount of net profit after taxes that the company retains for every dollar it earns from revenue or sales. By calculating the net profit margin, you will find the ratio of profit the company obtains from the total amount it generates.
Exceptions to the Rule
There are some exceptions to the net profit margin rule. Understanding the reasons and details requires a complex analysis of the DuPont return on equity formula. Below is the simplified version:
A sales-dependent company can achieve additional net profit by lowering its net profit margin and increasing sales when people buy goods from its stores. Dillard’s, a well-known store, has used this approach in the past. It had a net profit margin of 1.77% as of January 31, 2020. At that time, this was lower than other retailers like Walmart, which achieved 2.84% on the same date.
There is a constant risk in this approach when dealing with upscale brands. A business may start to wane when a trader loses its status in the public’s mind.
How to Find the Net Profit Margin
Traditional investor knowledge states that net profit after taxes should be divided by sales to find the net profit margin from the company’s income statement. While this is accepted as a standard, some people prefer to add minority interest to the equation. This will give you an idea of the amount the company earned before paying it to the minority shareholders.
Calculation Process
Any method for calculating the net profit margin can be accepted, but the same math should be used across companies for an equal comparison. All companies should be compared on the same basis.
All calculations can work like this:
Option 1: Net profit after taxes ÷ sales = net profit margin.
Option 2: Net profit + minority interest + tax-adjusted interest ÷ sales = net profit margin.
Again, a low net profit margin can signify a pricing strategy. It does not always mean that there is a failure on the management side. Some companies, especially retailers and chain hotels and restaurants, are known for their low-cost and high-volume approach.
In other cases, a low net profit margin may reflect a price war that shrinks profits. This was the case in the computer sector in 2000. More people were joining the personal computer sector, but not everyone was willing or able to pay the high prices. Sellers reduced prices to attract buyers. They even offered their products for free in exchange for advertising.
Example of Calculating Net Profit Margin
In 2009, Donna Manufacturing sold 100,000 units at $5 per unit with a cost of goods sold of $2 per unit. The company had $150,000 in operating expenses and paid $52,500 in income taxes. What is the net profit margin?
Start by finding the total sales to get the answer. Donna had total sales of $500,000 if she sold 100,000 units at $5 per unit. The cost of goods sold was $2 per unit, and 100,000 units at $2 per unit equals $200,000 in costs.
This leaves a gross profit of $300,000 (Total sales $500,000 – Cost of goods sold $200,000 = Gross profit $300,000). After subtracting $150,000 of operating costs from the gross profit, you have $150,000 as income before taxes. After deducting the tax bill, you are left with a net profit of $97,500.
Putting these numbers into the net profit margin formula, you will get: $97,500 net profit ÷ $500,000 total sales = 0.195 net profit margin, or 19.5%. Therefore, the answer is 0.195. Moving the decimal point, 19.5% is the net profit margin.
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