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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. Margin has slightly different meanings in financial accounting and investing.

Sellers have a keen interest in knowing their margins on individual products.

What is a Margin?

The term margin is used in business, finance, and investing in at least three different ways: 

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 being sold, expressed as a percentage of selling price.

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

The shop owner's margin on sales includes only the seller's direct cost for products or services. The margin does not reflect the costs of selling them (such as store leasing fees marketing costs, 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 own funds and borrowed funds. If the stock price changes between its purchase and sale, the result for the investor is leverage. This means that that the investor's percentage gain or loss is magnified compared to the percentage gain or loss had the investor purchased shares without borrowing. 

Explaining Margins in Context

Sections below further define, explain, 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

 

 

Contents

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 in Business Commerce

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

The Seller's Viewpoint

Sellers (vendors) generally refer to 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. Markups are expressed as a percentages of seller's 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 are sold in high volume, or if they leverage sales of higher margin products. On the other hand, with lower volume sales or the absence of product-to-product leverage, they normally concentrate selling resources on the higher margin products.

Calculating Margin on Sales

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

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 selling price may be determined by a chosen markup percentage.

  • In retail business, sellers typically use a pricing model that designates a given markup percentage. In such cases, 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 simply 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. Margin on sales does not include the seller's overhead costs for such things as store leasing fees. Nor does it include 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 Profits

The term margin, when used in accounting and financial reporting, refers to any of three "profit" lines on the Income statement. A margin, specifically, 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. This is 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 operating its normal line of business.

All three of the profit lines from the Income statement can also be expressed 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, net profit margin is net profit divided by net sales.

Note especially, however, that in some cases the Income statement does not distinguish between gross sales and net sales revenues. In those cases, margin percentages must of course be based on 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 important profitability metrics, of keen interest to the companys 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
   Dirct materials
   Direct labor
   Manufacturing Overhead
      Indirect labor
      Depreciation, mfr equipment
      Other mfr overhead
      Net mfr overhead
         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 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 profig 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 Investing

Investors who buy shares of stock or other securities partly with their own 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 own 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
Initial stock share price  $10 / share$10 / Share
Funds Available for Purchase  
Investor's own funds   
          Broker's funds loaned to investor  
Total funds for 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 price rise  $2,600 $1,300
Interest charges on margin loan  $50$0
Investor's funds after interest  
                         and repaying 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

The table below uses the same buying scenario to show how the investor loses by investing when the stock price falls. The  is shown both with margin buying allowed (middle column) and without (right column).

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

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


     $1,000
     $1,000
     $2,000

     $1,000
     $       0
     $1,000
   Shares purchased        200        100
   Stock share price after 30% price drop     $ 7 / share   $ 7 / share
Sale of stock after price drop     $1,400       $700
Interest charges on margin loan         $50         $0
Investor's funds after interest
and repaying 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 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 originally 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.
  • In order 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. This means essentially that the investor must repay part of the original margin loan. In this case, the investor must pay the broker about $300 to restore the brokers equity stake to 50%. After paying the margin call, the investor owes $700 to broker, because the 200 shares are now worth $1,400.

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