Net Profit Margin: Formula, Example, Benchmarks, Tips, And More!

net profit margin

Net profit margin, also known as the return on sales ratio or net margin, is an extensively utilized indicator to evaluate a business’s financial well-being.

Simply put, the metric tells you the percentage of total sales remaining after subtracting operational expenses, depreciation, amortization, interest, and income taxes.

To help you better understand what net profit margin is, in this article, we will walk you through all you need to know about the most widely used profitability metric.

What Is Net Profit Margin?

Net profit margin is a vital metric to measure how much profit you can generate as a percentage of total revenue. It is the Net Profit: Net Revenue ratio of your business or a business segment (we’ll discuss the formula more in-depth below).

Usually, the net margin is presented as (%); however, the metric can also be in decimal form to depict how much of a dollar in revenue translates to profits.

Net profit margin tells you how effectively you can manage to increase sales and optimize your business costs and expenses to maximize your net profit (also referred to as the bottom line):

  1. A high net profit margin means your costs are under control, your money is well-allocated, and your pricing strategy is on-point.
  2. A low net profit margin, by contrast, means the opposite: you may have failed at growing more sales or controlling your business expenses.

How to Calculate Net Profit Margin?

Here is the formula for net profit margin ratio:

Net Profit Margin = Net Profit / Net Sales

As seen, calculating net profit margin requires net profit and net sales. So to dig down further:

Net Profit Margin = Revenue COGS Operating & Other Expenses Interest Taxes

So here are three easy-to-follow steps to calculate your net margin:

  • Step 1: Subtract your total revenue from Cost of Goods Sold, Operating & other expenses, interest, and tax
  • Step 2: Divide the value from Step 1 by the total revenue
  • Step 3: Multiply the figure you get from Step 2 for 100%, and you’re all done.

NOTE: To improve your net profit margin, you must notice abnormal fluctuations and make timely adjustments (e.g., switch to a new supplier when COGS gets too high). So, calculating it annually at the end of the accounting year isn’t helping. You must do it daily.

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A Real-life Example Of Net Profit Margin

In order for you to have a better grasp of the metric, let’s calculate the net profit margin of a real business entity. Here is the consolidated income statement from IKEA – a giant furniture company based in the Netherlands.

a real-life example of net profit margin
Source: Inter IKEA Group Financial Summary FY21

Using data from the given statement, the net profit margin of IKEA for the fiscal year 2021 can easily be calculated as:

  1. Divide the net income by total revenues: €1,443m / €25,615m = 0.0563
  2. Mulitple the result to 100%: 0.0563 x 100%
  3. And you have the profit margin of IKEA, which is 5.63%. This means that every euro in revenue translates to €0.0563.

What Is a Good Net Profit Margin?

Is the 5.63% net profit margin figure of IKEA good? And what is a good net profit margin, anyway? Short answer: it depends!

Given that each business will have different models and cost structures, you must compare your net profit margin with brands in the same niche to know whether you’re doing well or not.

For instance, a net profit margin of 10% is considered slightly below the average for household product niche businesses (~11.25%). Meanwhile, if you’re selling clothes, it’s higher than an average apparel brand (~5.07%).

The data in the example above is from the net profit margin benchmark report by industry by New York University on 5,500+ US-based businesses as of January 2023.

How to Boost Your Net Profit Margin?

You can increase your sales and/or decrease your costs to improve your net margin. However, it’s easier said than done:

  • To increase your sales, you have to invest more in marketing initiatives and expansion. Unfortunately, this results in higher costs, which don’t always translate into higher sales and revenue.
  • What about decreasing costs? If you can manage to decrease costs without sacrificing the quality of your products or services, go ahead. But if a cost reduction leads to poorer product quality, you are risking losing customers.

So our advice for you is to invest more in branding activities in the long run. This is because brands with strong branding can offer the same products at higher prices – the best leverage to increase profit margin.

Some Limitations Of Net Profit Margin

No metric can give you a complete and clear picture of your business’s financial health. Net profit margin is no exception. Though it’s a crucial profitability metric, net profit margin doesn’t fully reflect your business’s financial well-being.

Here are some limitations of this metric:

  • It is displayed under percentage value. This means it’s not taking into account the actual amount of profit. In other words, net profit margins don’t reflect a company’s cash flow. Let’s take a look at the two simple instances below:
      1. Company A can have a net profit margin of 10% = $1,000 / $10,000. 
      2. Company B can have a net profit margin of only 5% = $5,000,000 / $100,000,000.
  • It can be affected by big changes in the income statement. For instance, you might see a drop in your net profit and net profit margin after investing much of your money into a one-time facility (e.g., a laboratory).

Though a high net profit margin is usually an ideal goal of most businesses, if you’re a newbie who has just launched your business, net profit margin shouldn’t be your ultimate goal. Let’s take a look at the business cycle model below:

If you’re new in the game, you’re expected to invest a lot in paid advertising on multiple channels, put effort into SEO your website, etc., to gain as much market share as possible. At this expansion stage, you should prioritize the market share.

Or, take another scenario, the recession stage. We recommend investing in basic infrastructure during this stage and diversifying your products to prepare for the new expansion. Again, net profit margin at this stage is also not something big of a deal that you should be head over heels about.

Net Profit Margin vs. Gross Profit Margin & Other Margins

Since net profit margin considers all costs involved in generating sales, it is more widely used to assess a business’s profitability comprehensively. 

Meanwhile, gross profit margin only takes into account the Cost of Goods Sold (COGS), ignoring all other costs and fees like fixed costs, overhead costs, interests, and taxes. Operating margin further looks at all the operating costs. Still, it excludes all the non-operating costs.

Quick fact: If your business doesn’t have non-operating costs, your net profit margin and operating margin are the same.

Usually, businesses with a high gross and operating margin will tend to have a high net profit margin. However, it’s not always the case since each margin has its own story to tell.

Frequently Asked Questions

  • What does a net profit margin of 20% mean?

As mentioned above, you have to compare your net margin with businesses in your niche. A 20% net profit margin is significantly impressive for all industries. However, the number is under the average net margin of banking industries (varying from 26%-31%)

  • Is a net profit margin of 7% good?

Again, this depends on the average net margin of your niche. If you’re in the apparel industry, a net profit margin of 7% is a good place to start.

Final Words

All in all, net profit margin is a crucial profitability metric that helps you gain valuable profit insights and financial health. 

However, improving your net margin isn’t an easy task. You have to spot all the fluctuations in your margin, find the reasons and fix them as soon as possible. Plus, you have to view the net profit margin together with other key metrics for a complete picture of your business and make more data-backed decisions.

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