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.
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:
- What is a margin?
- Margins in business sales: Seller' cost vs. selling price.
- What role do margins play in reporting earnings and profits?
- Example margins on the Income statement
- What is the role of margin when investing with borrowed funds?
- 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 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.
Calculating Margin on Sales
Consider, for instance, a product with the following characteristics:
Cost to Seller: $100
For a product with these characteristics:
Selling price = Cost + (Cost x Markup %)
Selling price = $100 + (0.25) x ($100)
Margin = (Selling price – Cost) / Selling price
Margin = ($125 – $100) / $125
= $25 / $125
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 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
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%|