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{"id":5631,"date":"2016-12-30T22:52:19","date_gmt":"2016-12-30T22:52:19","guid":{"rendered":"https:\/\/businessecon.org\/?p=5631"},"modified":"2023-08-11T15:58:30","modified_gmt":"2023-08-11T15:58:30","slug":"net-profit-margin","status":"publish","type":"post","link":"https:\/\/valueinvestingnow.com\/2016\/12\/net-profit-margin","title":{"rendered":"Net Profit Margin"},"content":{"rendered":"

Net Profit Margin<\/strong><\/span><\/h1>\n

The net profit margin reflects the profitability of the company as a percentage of net sales. It is one of the performance ratios used in evaluating business<\/span><\/strong><\/a>. Interestingly, some consider it the most important ratio. These users of business ratios take a very simplistic approach towards business evaluation. If the net profit margin is a set percentage, then simply increasing sales will generate larger profits to distribute to shareholders. This is their thinking in a two column format.<\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0\u00a0\u00a0Current\u00a0<\/span> \u00a0<\/strong>\u00a0 \u00a0 \u00a0\u00a0 25% Increase in Net Sales<\/span>\u00a0<\/strong><\/span>
\nNet Sales \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$500,000\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $625,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0<\/span>
\nNet Profit Margin \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 8.00%\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 8.00%<\/span>
\nProfit in Dollars \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $40,000\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $50,000<\/span><\/p>\n

It is never this simple as this article will explain.<\/span><\/p>\n

The ideal use of the net profit margin is as a standard to work with in maximizing profit dollars. To understand this, a user of this ratio must first grasp its meaning i comparison to the other profit ratios. Then the reader must also understand the fundamentals behind the ratio and its proper application. The final section will explain why the step up in net sales doesn’t correlate to equal step up in profit dollars. It is here that the other business principles impact the net profit margin and the final result.<\/span><\/p>\n

Net Profit Margin – Profit Points in Business<\/span><\/strong><\/span><\/h2>\n

There are actually three important profit points in business. To assist you in identifying them, look at this summary presentation of an income statement.<\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0COLE MOUNTAIN TIMBER<\/strong><\/span>
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Income Statement
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0For the Year Ending December 31, 2016<\/span><\/span><\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Dollars<\/span>\u00a0 \u00a0 \u00a0 \u00a0 Ratio %<\/span>
\n<\/span>Gross Sales \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$36,583,600\u00a0 \u00a0 \u00a0 103.74
\n<\/span>Adjustments \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 (1,318,300)<\/span>\u00a0 \u00a0 \u00a0 \u00a0 (3.74)<\/span>
\n<\/span>Net Sales \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a035,265,300\u00a0 \u00a0 \u00a0 100.00
\n<\/span>Costs of Production:
\n<\/span>\u00a0 \u00a0 – Cutting (Labor, Equipment, Fuel, ) \u00a0 19,873,100
\n<\/span>\u00a0 \u00a0 – Depletion \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 4,607,900
\n<\/span>\u00a0 \u00a0 – Seedlings\/Roads\/Compliance \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a04,101,700
\n<\/span>\u00a0 \u00a0 – Shipping\/Transportation \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a02,976,300
\n<\/span>\u00a0 \u00a0 – Other \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0 \u00a0 \u00a0962,400<\/span>
\n<\/span>\u00a0 \u00a0 Sub-Total Costs of Production \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 32,521,400
\n<\/span>Gross Profit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2,743,900\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 7.78\u00a0<\/strong>
\n<\/span>Expenses\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0 \u00a01,602,000
\n<\/span><\/span>Operational Profit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 1,141,900\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 3.24<\/strong>
\n<\/span>Interest & Taxes\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0799,400<\/span>
\n<\/span>Net Profit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$342,500\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 .97\u00a0<\/strong><\/span><\/span><\/p>\n

The three profit points are<\/span> gross, operating (operational) and net.<\/span><\/span><\/p>\n

Gross Profit<\/strong>\u00a0 – represents net sales less costs of sales. Costs of sales are all production costs including:
\n<\/span>Direct<\/strong> – Labor, labor burden, equipment utilization, materials, fuel, depletion (a form of allocation of the purchase<\/span>\u00a0price of the raw resource) and licensing.
\n<\/span>Indirect<\/strong> – Field management, communications, insurance, maintenance and construction of roads and drainage,\u00a0<\/span>replanting, monitoring, surveying, mapping etc.<\/span><\/span><\/p>\n

In some industries this cost is relatively a small percentage. For example, in food service, direct and indirect costs will run approximately 60 to 65% of net sales. Service industries have direct costs as low as 45% of net sales. In this particular company, Cole Mountain Timber, cost of sales is 92.22% of net sales leaving a meager 7.78% as the gross profit margin.<\/span><\/p>\n

Operational Profit (Operating Profit)<\/strong><\/span>\u00a0 – the operating profit reflects income after deducting general and overhead expenses. These include front and back office<\/span><\/strong><\/a> costs, marketing\/advertising, legal, compliance and miscellaneous.\u00a0\u00a0 Some industries include costs of capital (interest, depreciation and amortization) in expenses or separate and deduct them after operational profit. For simplicity, interest is separated out and included as a cost to derive net profit.<\/span><\/p>\n

Net Profit<\/strong><\/span>\u00a0 – The net profit is the final amount earned after deducting costs of capital and taxes. There is an interesting aspect of this value because each industry and its tax consequences are different. As an example, look at real estate investment trusts (REIT’s<\/span><\/strong><\/a>) net profit and operational profit. They are almost the same margin percentage of rents. This is because REIT’s are income tax free under the Internal Revenue Code.<\/span><\/p>\n

In the overall scheme of things, a .97% net profit margin appears small or so insignificant as to wonder, ‘Why be in business?’<\/span><\/p>\n

Each industry has its own peculiarities; with raw timber the lucrative components include land development, land sales, tax credits and of course the type of wood cut. It is highly likely that this respective year, Cole Mountain Timber was clearing land for a basic type of wood and had no land or development sales.<\/span><\/p>\n

A net profit margin in isolation, i.e. a single year is not an indicator of value. To understand this, the reader must gain familiarity with net profit margin fundamentals.<\/span><\/p>\n

Fundamentals of the Net Profit Margin<\/span><\/strong><\/h2>\n

The net profit margin serves as a standard of performance for a business. The idea is to develop (identify) the best performance year(s) and why other years failed to adhere to the ideal standard. For example, the following table identifies the net profit margin for a fast food restaurant over 11 years. A schedule attached includes criteria related to the outcomes.<\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 Year<\/span><\/strong>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0Net Sales<\/strong>\u00a0<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0Profit<\/strong><\/span>\u00a0 \u00a0 \u00a0Net Profit Margin<\/strong><\/span>
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2005 \u00a0 \u00a0 \u00a0 \u00a0 $3,877,209 \u00a0 \u00a0 \u00a0 \u00a0$286,616 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a07.39%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2006 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 3,918,483 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0271,009 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a06.92%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2007 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 3,941,677 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0301,061 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a07.64%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2008 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 3,416,815 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0203,581 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a05.96%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2009 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 4,176,997 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0261,475 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a06.26%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2010 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 4,233,018 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0400,103 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a09.45%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2011 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 4,106,222 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0347,467 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a08.46%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2012 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 3,897,886 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0304,505 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a07.81%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2013 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 3,902,210 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0311,617 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a07.98%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2014 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 3,972,176 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0267,409 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a06.73%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 2015 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 4,206,533<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0297,815<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 7.08%<\/span>
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $43,469,226 \u00a0 \u00a0 $3,252,658 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a07.45%
\n<\/span>\u00a0\u00a0\u00a0\u00a0 Average \u00a0 \u00a0$3,968,111 \u00a0 \u00a0 \u00a0 \u00a0$295,696<\/span><\/span><\/p>\n

Conditions<\/strong><\/span>\u00a0<\/span><\/p>\n

2008 – High turnover rate of employees required a $32,000 charge for human resources training and compliance software.
\n<\/span>2009 – Marketing fee in this year increased from 2% to 3% for the entire year on net sales per franchisor agreement.
\n<\/span>2009 – 2011 – Economic recession shifted consumer buying habits from sit-down style of eating to fast food as a replacement.
\n<\/span>2014 – A storm closed the restaurant for three days, clean-up costs and out-of-pocket repairs cost $19,642.<\/span><\/span><\/p>\n

The two best years are 2010 and 2011. 2009 had high sales at $4,176,977. If 2009 sales were adjusted for the additional 1% marketing fee, net profit would have been $303,245 (($261,475 * (.01 * $4,176,977)). \u00a0 Therefore, net profit margin equals 7.26% for 2009. Using 2009 through 2011 as the best performing periods, what is the average net profit margin?<\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0 \u00a0Year<\/strong><\/span>\u00a0 \u00a0 Net Sales<\/strong><\/span> \u00a0\u00a0 \u00a0 \u00a0 \u00a0Net Profit<\/strong><\/span>\u00a0 \u00a0Net Profit Margin<\/strong>\u00a0<\/span><\/span>
\n\u00a0*Adjusted 2009 \u00a0 $4,176,977 \u00a0 \u00a0 \u00a0 \u00a0 $303,245 \u00a0 \u00a0 \u00a0 \u00a0 \u00a07.26%\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0<\/span>
\n.<\/span> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2010 \u00a0 \u00a0 \u00a04,233,018 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0400,103 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 9.45%<\/span>
\n.<\/span> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2011 \u00a0 \u00a0 \u00a04,106,222<\/span> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0347,467<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a08.46%<\/span>
\n.<\/span> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $12,516,217 \u00a0 \u00a0 $1,050,815 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 8.40%\u00a0<\/span><\/p>\n

So why in 2015 didn’t the restaurant achieve at least a 7.26% net profit margin or even the upper tier standard of 8.4%? After all, net sales exceeded $4 Million just like 2009 – 2011. Review of 2015’s financials finds a couple of interesting charges. One is insurance premiums increased $18,000 related to the prior year storm damage claim. Secondly the franchisor mandated the use of certified environmental (health) inspections costing $28,000. Both these costs appear to be recurring from one year to the next going forward. This additional $46,000 per year in costs is approximately 1.16% of net sales. Therefore, the ideal standard of performance is 7.24% (8.40% – 1.16%) for the net profit margin.<\/span><\/p>\n

Over time, the franchisee will be able to charge more for some of the menu items in order to recoup the two additional costs of operations. For now the standard is 7.24%. Any value in excess identifies excellent performance. Any value within 80% is acceptable (5.79% to 7.24%). Any net profit margin below 5.79% is an indication of serious issues.<\/span><\/p>\n

For an owner of a business, the goal is to determine the optimum standard and an acceptable range below this standard (typically within 80% of the standard). Any variance is analyzed for one-time charges and operational improvement. With a standard, future financial reports can be evaluated. The\u00a0 fundamental purpose is to identify via the feedback loop method<\/span> in business causes of better performance or financial discrepancies. To do this, the other two profit points are put to work.<\/span><\/p>\n

Net Profit Margin – Analysis<\/span><\/strong><\/span><\/h2>\n

Once a standard of performance is identified; the net profit margin is used as a relational point of comparison to the other two points of profit to identify the areas (sections) of the income statement causing the discrepancy. Every business has a standard relationship between net profit and gross profit; and net profit and operational profit. For example, here is a professional services firm and their respective profit points and the corresponding relationships.<\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0SMITH, SMITH AND SMITH, P.C.<\/strong>
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0Brothers-In-Law<\/strong>
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Income Statement (Summary Format)
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 For the Year Ending December 31, 2016<\/span><\/strong><\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Financial<\/span><\/strong>\u00a0 \u00a0 \u00a0 \u00a0\u00a0\u00a0Ratio<\/span>\u00a0<\/strong>
\n<\/span>\u00a0\u00a0 Client Fees\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $3,209,742\u00a0 \u00a0 \u00a0 114.49%
\n<\/span>\u00a0\u00a0 Allowances\/Bad Debt \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0(409,209)<\/span>\u00a0 \u00a0 \u00a0(14.49%)<\/span>
\n<\/span>\u00a0\u00a0 Net Fees \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a02,803,533\u00a0 \u00a0 \u00a0100.00%
\n<\/span>\u00a0\u00a0 Cost of Services Rendered\u00a0\u00a0\u00a0 \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01,573,637<\/span>\u00a0 \u00a0 \u00a0 \u00a056.13%<\/span>
\n<\/span>\u00a0\u00a0 Gross Profit & Margin \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 1,229,896\u00a0 \u00a0 \u00a0 \u00a043.86%<\/strong>
\n<\/span>\u00a0\u00a0 Expenses (Overhead)\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 537,615<\/span>\u00a0 \u00a0 \u00a0 \u00a019.18%<\/span>
\n<\/span>\u00a0\u00a0 Operational Profit \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0692,281\u00a0 \u00a0 \u00a0 \u00a024.69%<\/strong>
\n<\/span>\u00a0\u00a0 Partner’s Tax Payments\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 309,600<\/span>\u00a0 \u00a0 \u00a0 \u00a011.04%<\/span>
\n<\/span>\u00a0\u00a0 Net Profit \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $382,681\u00a0 \u00a0 \u00a0 13.65%<\/strong><\/span><\/span><\/p>\n

Assuming that all three profit points are standard or normal, it now becomes easier to identify problem areas for any accounting period. Naturally any increase in cost for either costs of services or with expenses will reduce the net profit. As an example, assume expenses increased $12,000 due to rent increases. Now operational profit decreases to $680,281 (assumes all other items remain the same), what happens to the remaining ratios? Let’s take a look.<\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Financial<\/span><\/strong>\u00a0 \u00a0 \u00a0 \u00a0Ratio<\/span><\/strong>
\n<\/span>\u00a0\u00a0\u00a0 Operational Profit \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $680,281 \u00a0 \u00a0 \u00a0 24.27%
\n<\/span>\u00a0\u00a0\u00a0 Partner’s Tax Payments \u00a0 \u00a0 \u00a0\u00a0 \u00a0309,600<\/span>\u00a0 \u00a0 \u00a0 \u00a011.04%<\/span>
\n<\/span>\u00a0\u00a0\u00a0 Net Profit \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $370,681 \u00a0 \u00a0 \u00a013.22%\u00a0<\/span><\/span><\/p>\n

The .42% change in operational profit margin is directly reflected in the net profit margin. Net profit margin decreases from 13.65% to 13.22%. This is a 3.25% ((13.65\/13.22)-1) decrease in profitability. A $12,000 change in costs creates a significant (>3%) change in the final profit. This illustrates why it is so important to set a standard of profitability in a business. All other elements of the income statement are compared to this single standard for analysis.<\/span><\/p>\n

Caution<\/strong><\/span><\/p>\n

Setting standards is a tool designed to analyze and identify POTENTIAL<\/strong> problem areas. However, there may not be a problem. How so?<\/span><\/p>\n

Remember the primary goal of business, it is to make a profit. Dollars are what matters, not ratios. Let’s continue with the law firm and illustrate.<\/span><\/p>\n

Suppose the firm hires an associate and this associate handles complex business transactions. During the 2017 year, the associate generates $480,000 of additional net fees. However she is paid $320,00 including bonuses. All other items remain the same as a ratio (expenses) except for partner tax payments which are paid out at 44.72% of operational profit matching 2016. What does the income statement reflect and what are the corresponding ratios? Let’s take a look.<\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Financial<\/span>\u00a0<\/strong>\u00a0 \u00a0 \u00a0 \u00a0\u00a0Ratio<\/span><\/strong><\/span>
\nClient Net Fees (increases $480,000)\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$3,283,533\u00a0 \u00a0 \u00a0 \u00a0 100.00%<\/span>
\nCost of Services Rendered (up $320,000)\u00a0 \u00a0 \u00a0 \u00a0 1,893,637<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 57.67%<\/span>
\nGross Profit and Margin\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a01,389,896\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 42.33%<\/span>
\nExpenses\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0 \u00a0629,781<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 19.18%<\/span>
\nOperational Profit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 760,115\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 23.15%<\/span>
\nPartner’s Tax Payments (@44.72%)\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 339,923<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 10.35%<\/span>
\nNet Profit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$420,192\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 12.80%\u00a0<\/span><\/p>\n

Notice in this case the following relationships:<\/span><\/p>\n

\u00a0(A)<\/strong> Cost of services rendered as a percentage of net fees increased from 56.13% in 2016 to 57.67% in 2017 directly due<\/span> to her compensation package paid out at 66.67% ($320,000\/$480,000). This weights the overall cost of services<\/span>\u00a0higher.
\n<\/span>\u00a0(B)<\/strong> Expenses match 2016 as a ratio @19.18% of net fees.
\n<\/span>\u00a0(C)<\/strong> Operational profit as a percentage is 1.54% lower reflecting the same increase in cost of services (57.67% – 56.13%).
\n<\/span>\u00a0(D)<\/strong> Net profit margin decreased from 13.22% to 12.80%, a .42% decrease or a 3.28% overall decrease in total net<\/span>\u00a0profit margin.<\/span><\/span><\/p>\n

Most readers of financial reports would state that this is a significant decrease in margin and indeed it is significant. Yet in dollars the net profit increased $49,511. This goes back to old adage of ‘It is better to have a lower percentage of a larger number than a high percentage of a small value’. It is about dollars, not ratios!<\/span><\/p>\n

There is another aspect of the net profit margin in business. In some scenarios it represents the net contribution margin for a business. \u00a0<\/span><\/p>\n

In some industries, the net profit margin reflects the value of sales less variable costs less fixed costs. I’m referring to the elements of cost accounting (also known as managerial accounting). In cost accounting, cost of sales is referred to as variable costs. Expenses are equal to fixed costs and profit is referred to as contribution margin in excess of the breakeven point. In your high volume, stable price consumer products industries the fixed cost element remains stable so profit margins can increase across a range of production. Look at this illustration with fixed expenses of $500,000 per year for this widget manufacturer:<\/span><\/p>\n

Units of Production\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a01,000,000<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 1,200,000<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 1,500,000<\/span><\/strong>
\n<\/span>Sales Price per Unit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$2.25\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$2.25\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$2.25
\n<\/span>Net Sales\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$2,250,000\u00a0 \u00a0 \u00a0 \u00a0 $2,700,000\u00a0 \u00a0 \u00a0 \u00a0 $3,375,000
\n<\/span>Variable Costs (Cost of Sales)\u00a0 \u00a0 \u00a0$1.50\/unit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $1.50\/unit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $1.50\/unit
\n<\/span>Gross Contribution Profit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$750,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $900,000 \u00a0 \u00a0 \u00a0 \u00a0$1,125,000
\n<\/span>Fixed Costs (Expenses)\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0\u00a0 500,000<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0\u00a0 500,000<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0\u00a0\u00a0500,000<\/span>
\n<\/span>Profit\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$250,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $400,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$625,000
\n<\/span>Profit Ratio \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 11.11%\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 14.81%\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a018.52%\u00a0<\/span><\/span><\/p>\n

It would appear as if this increasing profit margin would continue infinitely. The reality is starkly different. The physical production is limited in capacity. Furthermore, the market demand is also limited to how many it can and will consume. If the range of capacity (production) is 1.5 million, the fixed costs to produce the next 1.5 million might or more likely are significantly more expensive than the first 1.5 million units of production. In addition it will most likely cost more per unit in variable costs to market the item as the manufacturer must resort to more expensive advertising avenues to find marginal customers to purchase the product.<\/span><\/p>\n

This is another reason why the net profit margin is not stable across a wide net sales range. Going back to the law firm example; to expand upon their business contract law division, the firm must add more office space, increase its legal resources (library, manuals, staff, geographical territory – increase in travel expenditures) and obtain the right to represent clients in federal court. Granted net client fees will increase, but so will the associated costs. The key is that costs for the marginal increase in revenue are less than other service related client fees thus adding to the bottom line. Remember, its about dollars and not the net profit ratio, i.e. net profit as a percentage of net sales.<\/span><\/p>\n

Summary – Net Profit Margin<\/span><\/strong><\/h2>\n

The net profit margin reflects the total dollars in net profit as a percentage of net sales. The best use of this ratio is as a standard of performance. Ideally, a user will want to establish a ratio average of several prosperous years during an economic cycle and use this value for the purpose of evaluating other years. By using the relationship of this ratio to both gross profit and operational profit margins, a user can analyze the source of discrepancies or efficiencies.<\/span><\/p>\n

However, the net profit margin is not the real goal; it is about dollars and a reader must stay on focus for profit dollars. The net profit margin merely acts as an identifier of potential problems or better corporate performance. ACT ON KNOWLEDGE<\/strong>.\u00a0<\/span><\/p>\n