It is never this simple as this chapter will explain.
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.
Profit Points in Business
There are actually three important profit points in business. To assist you in identifying them, look at this summary presentation of an income statement.
COLE MOUNTAIN TIMBER
For the Year Ending December 31, 2016
Dollars Ratio %
Gross Sales $36,583,600 103.74
Adjustments (1,318,300) (3.74)
Net Sales 35,265,300 100.00
Costs of Production:
– Cutting (Labor, Equipment, Fuel, ) 19,873,100
– Depletion 4,607,900
– Seedlings/Roads/Compliance 4,101,700
– Shipping/Transportation 2,976,300
– Other 962,400
Sub-Total Costs of Production 32,521,400
Gross Profit 2,743,900 7.78
Operational Profit 1,141,900 3.24
Interest & Taxes 799,400
Net Profit $342,500 .97
The three profit points are gross, operating (operational) and net.
Gross Profit – represents net sales less costs of sales. Costs of sales are all production costs including:
Direct – Labor, labor burden, equipment utilization, materials, fuel, depletion (a form of allocation of the purchase price of the raw resource) and licensing.
Indirect – Field management, communications, insurance, maintenance and construction of roads and drainage, replanting, monitoring, surveying, mapping etc.
In some industries this cost is relatively a small percentage. For example, in food service [link to page – Food Service Industry], 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.
Operational Profit (Operating Profit) – the operating profit reflects income after deducting general and overhead expenses. These include front and back office costs, marketing/advertising, legal, compliance and miscellaneous. Some industries include costs of capital (interest, depreciation and amortization) in expenses or separate and deduct them after operational profit. For simplicity, I separate interest out and include this as a cost to derive net profit.
Net Profit – 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) 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.
In the overall scheme of things, a .97% net profit margin appears small or so insignificant as to wonder, ‘Why be in business?’
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.
So 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.
Fundamentals of the Net Profit Margin
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.
Year Net Sales Profit Net Profit Margin
2005 $3,877,209 $286,616 7.39%
2006 3,918,483 271,009 6.92%
2007 3,941,677 301,061 7.64%
2008 3,416,815 203,581 5.96%
2009 4,176,997 261,475 6.26%
2010 4,233,018 400,103 9.45%
2011 4,106,222 347,467 8.46%
2012 3,897,886 304,505 7.81%
2013 3,902,210 311,617 7.98%
2014 3,972,176 267,409 6.73%
2015 4,206,533 297,815 7.08%
$43,469,226 $3,252,658 7.45%
Average $3,968,111 $295,696
2008 – High turnover rate of employees required a $32,000 charge for human resources training and compliance software.
2009 – Marketing fee in this year increased from 2% to 3% for the entire year on net sales per franchisor agreement.
2009 – 2011 – Economic recession shifted consumer buying habits from sit-down style of eating to fast food as a replacement.
2014 – A storm closed the restaurant for three days, clean-up costs and out-of-pocket repairs cost $19,642.
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)). 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?
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.
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.
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 fundamental purpose is to identify via the feedback loop method in business causes of better performance or financial discrepancies. To do this, the other two profit points are put to work.
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.
SMITH, SMITH AND SMITH, P.C.
Income Statement (Summary Format)
For the Year Ending December 31, 2016
Client Fees $3,209,742 114.49%
Allowances/Bad Debt (409,209) (14.49%)
Net Fees 2,803,533 100.00%
Cost of Services Rendered 1,573,637 56.13%
Gross Profit & Margin 1,229,896 43.86%
Expenses (Overhead) 537,615 19.18%
Operational Profit 692,281 24.69%
Partner’s Tax Payments 309,600 11.04%
Net Profit $382,681 13.65%
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.
Operational Profit $680,281 24.27%
Partner’s Tax Payments 309,600 11.04%
Net Profit $370,681 13.22%
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. So 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.
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.
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.
Notice in this case the following relationships:
(A) Cost of services rendered as a percentage of net fees increased from 56.13% in 2016 to 57.67% in 2017 directly due to her compensation package paid out at 66.67% ($320,000/$480,000). This weights the overall cost of services higher.
(B) Expenses match 2016 as a ratio @19.18% of net fees.
(C) Operational profit as a percentage is 1.54% lower reflecting the same increase in cost of services (57.67% – 56.13%).
(D) Net profit margin decreased from 13.22% to 12.80%, a .42% decrease or a 3.28% overall decrease in total net profit margin.
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!
There is another aspect of the net profit margin in business. In some scenarios it represents the net contribution margin for a business.
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:
Units of Production 1,000,000 1,200,000 1,500,000
Sales Price per Unit $2.25 $2.25 $2.25
Net Sales $2,250,000 $2,700,000 $3,375,000
Variable Costs (Cost of Sales) $1.50/unit $1.50/unit $1.50/unit
Gross Contribution Profit $750,000 $900,000 $1,125,000
Fixed Costs (Expenses) 500,000 500,000 500,000
Profit $250,000 $400,000 $625,000
Profit Ratio 11.11% 14.81% 18.52%
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.
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.
Summary – Net Profit Margin
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.
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.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.