Understanding Profit Margins

A profit margin is profit divided by revenue, expressed as a percentage. There are three that matter, taken at three points down the income statement, and each answers a different question about where the money goes between a sale being made and a profit being reported.

The same £1 of revenue at a software firm and a supermarket

A pound of software revenue costs 22p to deliver, because the marginal cost of another licence is close to nothing. A pound of grocery revenue costs 75p because someone had to buy the food. Neither business is better run than the other. They are different businesses, and the only conclusion available from this table is that comparing margins across unrelated industries produces nonsense.

The comparison that does work is against the same company last year and against direct competitors. A grocer at 3.5% operating margin against peers at 4.2% keeps 0.7p less of every pound it sells, which is a sixth less profit on identical revenue, and that gap is worth a great deal more attention than the fact that a software company earns more per pound.

One more reading before leaving the table. The distance between gross and operating margin is the cost of running the company rather than of making the product: 53 points for the software firm, 21.5 for the grocer. The software business spends far more of each pound on sales teams, engineers and support than the retailer spends on head office, and that spending is discretionary in a way that the cost of food is not. Which means the software margin is more controllable and therefore more likely to be managed, in both the good sense and the bad one.

Operating leverage: why a 4% revenue miss cuts profit 16%

Take a company with £500m revenue, 40% gross margin and £150m of largely fixed operating costs. Gross profit is £200m, operating profit is £50m, so the operating margin is 10%.

Now revenue falls 4% to £480m. Gross profit falls to £192m. Operating costs stay at £150m because rent, salaries and systems do not fall when sales do. Operating profit is £42m, a 16% decline from a 4% revenue decline. The amplification is four times, and it runs in both directions: a 4% revenue increase would have lifted operating profit 16% as well.

This is the single most useful piece of arithmetic in company analysis, because it explains why share prices move so violently on modest revenue surprises. It also tells you which companies to expect violence from, and that is a sizing input before it is a selection one: a business with an amplification factor of four warrants a smaller position for the same risk than one with a factor of one and a half. The higher the proportion of fixed costs, the larger the amplification, which is why airlines, manufacturers and cinema chains swing far harder on a small demand change than a business whose costs scale with each sale.