Deliver Credibility, Accuracy, Practical Value
Solution Matrix Ltd®

# Margins in Business, Finance, and Investing Definition, Meaning Explained, Example Calculations

In business and commerce generally, margin refers to the difference between the seller's cost for acquiring products and the selling price. Margins appear as percentages of net sales revenues. The term "Margin" has slightly different meanings in financial accounting and investing.

## What is a Margin?

For businesspeople in commerce, finance, and investing the term "Margin" has in at least three different meanings:

### First Meaning: Margins in Business Commerce

As a general term in business and commerce,  margin refers to the difference between selling price and the seller's costs for the goods or services on sale, expressed as a percentage of selling price.

A retail shop owner, for instance, may purchase finished goods inventory from a supplier at the cost of \$8 per item. If the product sells for \$10, the shop earns a margin on sales of 20% on it.

The shop owner's margin on sales includes only the seller's direct cost for products or services. The margin does not reflect expenses for selling them (such as the fees for store leasing fees or marketing, or salesperson wages), and not business overhead costs (such as computer systems for the business or management salaries).  However, operating costs and overhead costs do factor into other margins—the operating margin and net profit margin for the business.

### Second Meaning: Margins in Financial Accounting

In financial accounting, margin refers to three specific Income statement calculations. Each appears as a percentage of sales revenues: gross margin, operating margin, and net profit margins. Owners, managers, and analysts look to all three of these margins as measures of the company's earning performance.

### Third Meaning: Margins in Investing

As an investment term, margin refers to buying shares of stock or other securities with a combination of the investor's funds and borrowed funds. If the stock price changes between its purchase and sale, the result for the investor is leverage. "Leverage" means that that the investor's percentage gain or loss magnifies compared to the percentage gain or loss had the investor purchased shares without borrowing.

### Explaining Margins in Context

Sections below further define and illustrate margins in all three senses. Examples appear in context with related terms including the following:

Gross Profit

Gross Margin

Operating Profit
Operating Margin

Net Profit

Profit Margin
Investor Leverage

Profitability

Markup

## Related Topics.

• For in-depth coverage of the financial Income statement, see Income Statement.
• See Expense for more on the role of expenses in creating Income statement margins.
• For more on financial metrics for measuring profits, see Profitability.
• See Sales Revenues for more on the role of revenues in financial accounting.

Margins are central concerns for every business that sells goods and services. Owners and managers at retail shops, product manufacturers, wholesalers, and service providers all take a keen interest in tracking their margins throughout the accounting period.

### The Seller's Viewpoint

Sellers (vendors) generally refer to the margin as the difference between their cost for an item and the selling price, expressed as a percentage of the selling price.

• The difference between seller's cost and the selling price, itself, is known as markup. Sellers express markup as a percentage of their "cost."
• The term margin used in this way means the same thing as margin on sales.
Sellers, large and small, have a keen interest in knowing their margin on individual products. On the one hand, they may be quite willing to accept low margins if the products sell in high volume, or if they leverage sales of other products with higher margins. On the other hand, sellers with lower volume sales or the absence of product-to-product leverage, they usually concentrate sales resources on higher-margin products.

### Calculating Margin on Sales

Consider, for instance, a product with the following characteristics:

The cost to Seller: \$100
Markup: 25%

For a product with these characteristics:

Selling price = Cost + (Cost x Markup %)
Selling price = \$100 + (0.25) x (\$100)
= \$125

Margin = (Selling price – Cost) / Selling price
Margin = (\$125 \$100) / \$125
= \$25 / \$125
= 20%

### Setting Prices and Choosing a Markup Percentage

Selling price may be the direct choice of the seller, or a chosen markup percentage may determine the selling price.

• In retail businesses, sellers typically use a pricing model that designates a given markup percentage. In such cases, the selling price is determined entirely by the seller's cost and the prescribed markup percentage. By this approach, the seller can achieve a target margin level.
• Where there is a competitive market, however, sellers may have to designate a price based on prevailing market prices and merely accept the resulting markup and margin.

When margin refers to this kind of margin on sales, the term has in view only the seller's costs for items sold. The margin on sales does not include the seller's overhead costs for such things as store leasing fees. Nor does it cover general overhead costs for such things as management salaries. Here, the term is very close in meaning to what accountants call gross margin (see following sections).

## The Role of Margins in Reporting Earnings and ProfitsBut How Long is Life?

The term margin, when used in accounting and financial reporting, refers to any of three "profit" lines on the Income statement. A margin, precisely, is a profit figure expressed as a percentage of the company's net sales revenues.

### Income Statement Profits

The Income statement generally shows how income figures result by subtracting the entity’s costs and expenses from its total sales revenues.

Income = All Revenues - All expenses

Note, by the way, that reported income, revenues, and expenses do not necessarily represent real cash inflows or outflows. They are not necessarily cash flow, because regulatory groups, standards boards, and tax authorities, allow or require companies to use conventions such as depreciation expense, allocated costs, and accrual accounting on the Income statement. Actual cash flow gains and losses for the period are reported more directly on another reporting instrument, the Statement of Changes in Financial Position (or cash flow statement).

### Three Kinds of Profits and Three Margins

Bottom line net income on sales (net profits on sales) is a measure of the company's financial performance for the period, but the Income statement contains other performance metrics as well. The difference between net sales revenues and cost of goods sold is called gross profits, for instance, while the net income from operations—before taxes and before gains and losses from financial and extraordinary items—is called operating income (or operating profits). "Operating profit," in other words, represents the firm's earnings from operations in its usual line of business.

All three of the profit lines from the Income statement can also appear as a percentage of net sales, that is, as margins. Exhibit 1 below shows the possibilities.

• Firstly, gross margin is gross profit divided by net sales as shown in the table below.
• Secondly, operating margin is operating profit divided by net sales.
• Thirdly, the net profit margin is net profit divided by net sales.

Note, however, that in some cases the Income statement does not distinguish between gross sales and net sales revenues. In those cases, margin figures must, of course, represent percentages of "gross" sales.

 Net Sales = 32,983 Margin = Profit / Sales Revenues Gross Profit = 10,940 Gross Margin = 10,940 / 32,983 = 33.2% Operating Profit = 3,130 Operating Margin = 3,130 / 32,983 = 9.5% Net Profit = 3,130 Profit Margin = 2,126 / 32,983 = 6.4%

Exhibit 1.Income statement figures can be used to calculate three margins: gross margin, operating margin, and (net) profit margin.

In brief, margins serve as essential profitability metrics, of keen interest to company management, employees, competitors, and shareholders.  For more on margins as profitability metrics, along with other profitability metrics, see Profitability.

## Example Margins on the Income Statement

The profit margin examples above use data from the sample Income statement below in Exhibit 2.

 Grande Corporation                                   Figures in \$1,000's Income Statement for Year Ended 31 December 20YY Revenues Gross sales revenues    "Less" returns & allowances       Net sales revenues Cost of goods sold    Direct materials    Direct labor    Manufacturing Overhead       Indirect labor       Depreciation, mfr equipment       Other mfr overhead       Net mfr overhead          The Net cost of goods sold Gross Profit 5,263 360   4,000 33,329     346 6,320   6,100 9,623 32,983  22,043  10,940 Operating Expenses Selling expenses    Sales salaries    Warranty expenses    Depreciation, Store equip    Other selling expenses           Total selling expenses General & Admin expenses    Administrative salaries    Rent expenses    Depreciation, computers    Other general & admin expenses       Total general & admin exp            Total operating expenses Operating Income Before Taxes 4,200   730   120    972 1,229 180 179    200 6,022   1,788 7,810   3,130 Financial revenue & Expenses   Revenue from investments       Less interest expense       Net financial gain (expense)   Income before tax & ext items   Less income tax on operations     Income before extraordinary items 118   511 (393)  2,737   958 1,779 Extraordinary Items    Sale of land    Less initial cost       Net gain on sale of land       Less income tax on the gain          Extraord items after tax 610   145 465   118 347 Net Income (Profit) 2,126

Exhibit 2. Income statement with figures for calculating margins: Gross margin, operating margin, and profit margin.

### Further Income Statement Resources

• See the article Income statement for more on the structure and uses of the Income statement itself.
• See the article Profitability for more on profitability metrics, including Gross margin, Operating Margin, and Profit margin on sales.
• The spreadsheet tool Financial Metrics Pro also has more in-depth coverage of these topics along with working examples, templates, and a complete system of interrelated metrics and financial statements.

## The Meaning of Margin in Borrowing Funds for InvestingInvesting on Margin Creates Leverage

Investors who buy shares of stock or other securities partly with their funds, and partly with funds borrowed from the broker, are buying on margin.

### How Does Margin Create Investor Leverage?

Buying on margin creates leverage. Leverage provides the investor with an opportunity to magnify investor gains from given size if the stock price rises. At the same time, buying on margin increases investment risk, because the investor's losses also increase if the stock price if the stock price falls.

### Example: Stock Price Rises and Investor Gain Increases

The table below illustrates how the investors gain by investing \$1,000 of their funds when the stock price rises. The gain is shown both with "buying on margin" (middle column) and without margin (right column).

INVESTOR LEVERAGE WHEN STOCK RISES With 50% MarginWithout Margin
The initial stock share price  \$10 / share\$10 / Share
Funds Available for Purchase
Investor's funds
Broker's funds loaned to investor
Total funds for z purchase

\$1,000
\$1,000
\$2,000

\$1,000
\$       0
\$1,000
Shares purchased   200 100
Stock share price with 30% price rise  \$13 / share\$13 / share
Sale of stock after the price rise  \$2,600 \$1,300
Interest charges on a margin loan  \$50\$0
Investor's funds after interest
and repaying a margin loan
\$1,550\$1,300
Investors net gain/(loss)
on \$1000 investment
\$550 or 55% \$300 or 30%

### Example: Stock Price Falls and Investor Loss Increases

This table shows this effect for two situations: (1) with margin buying allowed (middle column) and (2) without (right column).

INVESTOR LEVERAGE WHEN STOCK FALLS With 50% Margin Without  Margin
The initial stock share price  \$10 / share  \$10 / Share

Funds Available for Purchase
Investor's funds
Broker's funds loaned to investor
Total funds for a purchase

\$1,000
\$1,000
\$2,000

\$1,000
\$       0
\$1,000
Shares purchased        200        100
The stock share price after 30% a price drop    \$ 7 / share   \$ 7 / share
Sale of stock after price drop     \$1,400       \$700
Interest charges on the margin loan         \$50         \$0
Investor's funds after interest
and repaying the margin loan
\$350      \$700
Investor's net gain/(loss)
on \$1000 investment
(\$650) or -65% (\$300) or -30%

### Margin Calls When the Share Price Drops

When the stock price falls, moreover, the broker may send a margin call to the investor, requiring that the investor contribute funds to restore the original equity (ownership) balance in the position. As an example, consider the "loss" scenario above:

• The broker initially contributed 50% towards the total purchase price of \$2,000. As a result, the investor owes the broker 50% of the stock value (\$1,000).
• After the 30% reduction in stock price, to \$7 per share, the market value of the 200 shares fell to \$1,400.  However, the investor still owes the broker \$1000.
• The broker originally took a 50% equity position in the investment purchase. After the price drop, the broker's equity position rose to about 71%. (\$1,000 is 715 of \$1,400). At this point, the broker issued a margin call.
• To bring the broker's stake in the investment back down to the original 50% level, the investor must pay the broker's margin call. Paying the margin call means that the investor must repay part of the initiial margin loan. In this case, the investor must pay the broker about \$300 to restore the broker's equity stake to 50%. After paying for the margin call, the investor owes \$700 to the broker, because the 200 shares are now worth \$1,400.