Advantages & Disadvantages of Profit Margin

Profit margin is a way of measuring a company's profitability, often expressed as a percentage of the total sales revenue. The use of profit margin helps a company assess the level of its costs relative to profit and sales. By improving cost efficiency, companies may further increase their profit margin, given the same sales revenue. Companies may also use profit margin for price control because of the direct relationship between profit and price on a per-unit basis. However, using profit margin doesn't help with gauging a company's sales volume, which affects a company's total profit.

In profitability measurement, companies need to know how much sales dollars they're able to retain after deducting all costs from sales. The more sales dollars left after covering all costs, the more profitable the sales are. A profit margin is thus part of the sales revenue not used to pay for any costs, and defined as profit divided by sales revenue. An advantage of using profit margin is that it allows the direct comparison between profit and costs at any given sales level. Any cost savings contributes to extra profit margin.

Companies may also influence profit margin by effecting sales price. Using profit margin as a benchmark, companies have a basis on which to formulate their pricing strategies. By comparing their current profit margin with past average or industry norms, companies may need to raise their profit margin or be able to tolerate a lower profit margin by increasing or decreasing their sales prices. Without the use of profit margin, companies have to find other ways to quantify any price change to reflect its potential effect on profitability.

Even though cost and profit are closely related in calculating profit margin, one disadvantage of using profit margin is that profit margin alone doesn't reveal the true cost efficiency in realizing sales. Although lower or higher costs change a company's profit margin, an increase or decrease in profit margin may have nothing to do with changes in cost efficiency if the company has opted for price change without any adjustments made to cost elements. Thus, to use profit margin for cost-efficiency assessment, the price level must also be a known factor.

Profit margin alone can't determine a company's total profit level without accounting for total sales volume. Companies may have a high profit margin but low sales volume, leading to a relatively low total profit. If the high profit margin comes from higher price rather than lower costs, sales volume may decrease over time. On the other hand, companies may have a low profit margin but high sales volume, resulting in a relatively high total profit. If the low profit margin comes from lower price rather than higher costs, sales volume may increase over time.