Course 204: Different Types of Profit Margins
Types of Margin
In this course
1 Introduction
2 Types of Margin
3 How Margins Interact

To understand the differences between the three major types of margin, it helps to break down a company's expenses into three parts. First, there is the cost of goods sold, or cost of revenues. This represents the expenses most directly involved in creating revenue, such as raw materials and labor costs for a manufacturer or the wholesale price of goods for a retailer. Subtracting cost of goods sold from revenue gives gross income, and dividing that figure by revenue gives gross margin. This number is close to most people's intuitive notion of profit margin. For example, if it costs you $8 to make a widget and you sell it for $10, your gross margin is $2 divided by $10, or 20%. But any business of a reasonable size will also have expenses that are less directly involved in creating revenue. These are called operating expenses and include costs for marketing, research and development, and administrative salaries--more peripheral expenses that are nonetheless necessary for the company's everyday operations and that are particularly necessary for the company to grow. Subtracting both cost of goods sold and operating expenses from revenue gives you the company's operating income. Operating margin equals operating income divided by revenue. This figure provides a more accurate picture than gross margin of how profitable a company's overall day-to-day operations are. In our example, suppose you spend $1 to advertise your widget; that cuts your 20% gross margin down to a 10% operating margin. Finally, there are expenses that are not related to the day-to-day operations of the company but that have to be accounted for: costs such as interest expense, taxes, and some noncash charges such as write-offs. Subtracting these expenses from operating income results in net income, which in turn is used to calculate net margin. This is the margin figure you'll find in most sources of stock information, since it's the most accurate measure of how profitable a company is when everything is taken into account. If in the widget example, you have to pay $0.50 in tax on your $1.00 operating profit, you are left with a net margin of 5%.

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