Net Profit Margin (NPM) is ratio between Net Profit Before Interest and TAX, and Sales Revenue. It compares Net Profit Before Interest and TAX with Sales Revenue.
What does Net Profit Margin (NPM) measure?
Net Profit Margin (NPM) shows Net Profit Before Interest and TAX as a percentage of Sales Revenue. This ratio tells us how much Net Profit Before Interest and TAX is earned from USD$1 of Sales Revenue.
Net Profit Margin (NPM) measures how well the business is converting Sales Revenue into Net Profit Before Interest and TAX. It measures how well the business adds value to the firm’s total costs. It is a good indicator of how effectively managers controlled both the cost of production Cost of Goods Sold (COGS) and Expenses (Overheads).
Net Profit Margin (NPM) is a better measure of a firm’s profitability than Gross Profit Margin (GPM) as it accounts for all costs (both directly and indirectly related to production). It makes Net Profit Margin (NPM) being a good indicator of management effectiveness at converting Sales Revenue into profit after all production costs and expenses, but before Interest, TAX and dividends.
The difference between Gross Profit Margin (GPM) and Net Profit Margin (NPM) shows the effect that Expenses (Overheads) have on the profits of a business. As Net Profit Before Interest and TAX will always be lower than Gross Profit unless Expenses (Overheads) equal zero which is theoretically possible but practically unlikely.
Net Profit Margin (NPM) measures how well the business adds value the firm’s total costs. Add, how well the business’s managers control all its costs both the cost of production and expenses.
How to calculate Net Profit Margin (NPM)?
The figures for working out Net Profit Margin (NPM) can be found in Profit and Loss Account (P&L Account):
| Net Profit Before Interest and TAX | |||
| Net Profit Margin (NPM) = | ━━━━━━━━━━━━━━━━━━━━ | x 100 | |
| Sales Revenue |
It is common practice to use Net Profit Before Interest and TAX to calculate profitability of a business because it allows historical comparisons to be made. Net Profit After Interest and TAX is subject to change caused by fluctuating interest rates and TAX rates in a country. Both interest rates and TAX rates are decided by the government, hence beyond the control of a business and its managers.
Comment
Net Profit Margin (NPM) is expressed as a percentage.
If a business has Sales Revenue of USD$1,000,000 and Net Profit Before Interest and TAX of USD$350,000, then Net Profit Margin (NPM) is 35%. If Net Profit Margin (NPM) is 35%, it means that for every USD$100 of Sales Revenue, USD$35 is Net Profit Before Interest and TAX and USD$65 is the cost of production Cost of Goods Sold (COGS) and Expenses (Overheads). So, the cost of production and Expenses (Overheads) account for 65% of Sales Revenue. USD35$ is the amount of Net Profit Before Interest and TAX that is left after all costs are accounted for (both directly and indirectly related to production).
Net Profit Margin (NPM) will be different for different industries. The higher the Net Profit Margin (NPM) the better – the company better controls all its costs.
The difference between a firm’s Gross Profit Margin (GPM) and Net Profit Margin (NPM) represents Expenses (Overheads). When the difference between Gross Profit Margin (GPM) and Net Profit Margin (NPM) is large, this suggests that Expenses (Overheads) are high. When the difference between Gross Profit Margin (GPM) and Net Profit Margin (NPM) is small, this suggests that Expenses (Overheads) are low.
Example for Net Profit Margin (NPM)
COMPANY A
Company A has Sales Revenue of USD$1,000,000, Cost of Goods Sold (COGS) of USD$700,000, Gross Profit of USD$300,000, Expenses (Overheads) of USD$150,000 and Net Profit Before Interest and TAX of USD$150,000 in 2020. One year later in 2021, Company A has Sales Revenue of USD$1,500,000, Cost of Goods Sold (COGS) of USD$600,000, Gross Profit of USD$900,000, Expenses (Overheads) of USD$100,000 and Net Profit Before Interest and TAX of USD$800,000.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Sales Revenue | $1,000,000 | $1,500,000 | |||||
| Cost of Goods Sold (COGS) | $700,000 | $600,000 | |||||
| Gross Profit | $300,000 | $900,000 | |||||
| Gross Profit Margin (GPM) | 30% | ➚ | 60% | ||||
| Expenses (Overheads) | $150,000 | $100,000 | |||||
| Net Profit Before Interest and TAX | $150,000 | $800,000 | |||||
| Net Profit Margin (NPM) | 15% | ➚ | 53.3% | ||||
| The difference between GMP & NPM: | 15% | 6.7% |
What happened? Net Profit Margin (NPM) in 2020 was 15%. The result tells us that every USD$1 of Sales Revenue earned USD$0.15 of Net Profit Before Interest and TAX in 2020. The cost of production Cost of Goods Sold (COGS) and Expenses (Overheads) were USD$0.85. However, in 2021, Net Profit Margin (NPM) increased from 15% to 53.3%. The result tells us that every USD$1 of Sales Revenue earned USD$0.533 is Net Profit Before Interest and TAX in 2021. The cost of production Cost of Goods Sold (COGS) and Expenses (Overheads) were USD$0.467.
Why it happened? It happened because Expenses decreased from $150,000 in 2020 to $100,000 in 2021. This caused Net Profit Before Interest and TAX to increase from $150,000 in 2020 to $800,000 in 2021.
What does the change mean? Company A’s Net Profit Margin (NPM) is higher as the company managed to increase its revenue and lower the cost of production having lower cost of sales while at the same time lowering expenses. The management of Company A was more effective in controlling both production costs and expenses in 2021 comparing with 2020. The profitability gap between GPM and NPM has narrowed from 15% in 2020 to 6.7% in 2021. This suggests that the company has relatively lower Expenses (Overheads) impacting on higher Net Profit Before Interest and TAX compared with Sales Revenue.
Is it good or bad for the business? This is good for Company A as it now has higher Net Profit Before Interest and TAX. A comparison of results indicates that the profitability of Company A was improving both when it comes to Gross Profit Margin (GPM) and Net Profit Margin (NPM). The higher the Net Profit Margin (NPM) the better – the company better controls all its costs.
COMPANY B
Company B has Sales Revenue of USD$1,000,000, Cost of Goods Sold (COGS) of USD$700,000, Gross Profit of USD$300,000, Expenses (Overheads) of USD$150,000 and Net Profit Before Interest and TAX of USD$150,000 in 2020. One year later in 2021, Company B has Sales Revenue of USD$900,000, Cost of Goods Sold (COGS) of USD$720,000, Gross Profit of USD$180,000, Expenses (Overheads) of USD$160,000 and Net Profit Before Interest and TAX of USD$20,000.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Sales Revenue | $1,000,000 | $900,000 | |||||
| Cost of Goods Sold (COGS) | $700,000 | $720,000 | |||||
| Gross Profit | $300,000 | $180,000 | |||||
| Gross Profit Margin (GPM) | 30% | ➘ | 20% | ||||
| Expenses (Overheads) | $150,000 | $160,000 | |||||
| Net Profit Before Interest and TAX | $150,000 | $20,000 | |||||
| Net Profit Margin (NPM) | 15% | ➘ | 2.2% | ||||
| The difference between GMP & NPM: | 15% | 17.8% |
What happened? Net Profit Margin (NPM) in 2020 was 15%. The result tells us that every USD$1 of Sales Revenue earned USD$0.15 of Net Profit Before Interest and TAX in 2020. The cost of production Cost of Goods Sold (COGS) and Expenses (Overheads) were USD$0.85. However, in 2021, Net Profit Margin (NPM) decreased from 15% to 2.2%. The result tells us that every USD$1 of Sales Revenue earned, USD$0.022 is Net Profit Before Interest and TAX in 2021. The cost of production Cost of Goods Sold (COGS) and Expenses (Overheads) were USD$0.978.
Why it happened? It happened because Expenses increased from $150,000 in 2020 to $160,000 in 2021. This caused Net Profit Before Interest and TAX to decrease from $150,000 in 2020 to $20,000 in 2021.
What does the change mean? Company B’s Net Profit Margin (NPM) is lower as the company saw the decrease in its revenue and increase in the cost of production having higher cost of sales while at the same time facing higher expenses. The management of Company B was less effective in controlling both production costs and expenses in 2021 comparing with 2020. The profitability gap between GPM and NPM has widened from 15% in 2020 to 17.8% in 2021. This suggests that the company has relatively higher Expenses (Overheads) impacting on lower Net Profit Before Interest and TAX compared with Sales Revenue.
Is it good or bad for the business? This is bad for Company B as it now has lower Net Profit Before Interest and TAX. A comparison of results indicates that the profitability of Company B was deteriorating both when it comes to Gross Profit Margin (GPM) and Net Profit Margin (NPM). The lower the Net Profit Margin (NPM) the worse – the company worse controls all its costs.
How to improve Net Profit Margin (NPM)?
Net Profit Margin (NPM) is influenced by both Sales Revenue, the cost of production Cost of Goods Sold (COGS) and Expenses (Overheads). This means that a business can improve its Net Profit Margin (NPM) by increasing Gross Profit through increasing Sales Revenue and decreasing the cost of production Cost of Goods Sold (COGS) as well as decreasing Expenses (Overheads).
1. Increase Sales Revenue:
- Increase quantity sold. Simply selling more products by using appropriate marketing strategies. Managers can attract more customers to raise sales by making the marketing of a firm more effective. What are the possible marketing strategies?
- Using new promotion methods or changing current ineffective promotion methods;
- Product extension strategies preventing the product from entering the decline stage in Product Life Cycle;
- Innovating new products to enlarge Product Portfolio;
- Entering into new markets to find new customers;
- Targeting new market segments to sell to different types of customers;
- Repackaging to make the product more appealing to customers, however, this will raise the firm’s expenses.
- Using E-Commerce or other distribution channels to make the products available to customers in more places.
Managers can also grow the business by increasing its production and selling capacity through opening more shops, hiring more sales personnel, taking over another business, etc.
- Change the price. The business can either increase the price or decrease the price. Changing the price raises the value of each item sold, but may cause a fall in the volume of sales. How to make altering the price work to gain competitive advantage?
- Reduce the selling price of products. For elastic products managers should decrease the price to sell more. Also, for products which there are many substitutes on the market. Additionally, for products with poor brand loyalty.
- Raise the selling price of products. For inelastic products managers should increase the price to boost Sales Revenue. Also, for products which there are few substitutes on the market, or for complementary products. Additionally, for products with strong brand loyalty.
Ideally, raising the price of the product should be done with no significant increase in Variable Costs (VC). Also, changing the price may damage the long-term image of the business.
- Seek alternative revenue streams. While the most common revenue stream for many businesses is from selling products to individual customers and other businesses, there are many other non-operating revenue streams that the business ought to explore such as advertising revenue, subscription revenue, merchandise revenue, renting or leasing assets, etc. This will boost sales revenue for non-core business activities, particularly when affected by seasonal demand.
2. Decrease cost of production Cost of Goods Sold (COGS):
- Cut direct material costs:
- Use cheaper raw materials. Use replacements which look similar and have similar function, but are much cheaper to find. For example, use artificial leather instead of real leather to make shoes while charging the same prices. Some furniture producers are using particle boards instead of real wood to manufacture tables and cabinets. However, this may negatively impact the perceived product quality.
- Use less raw materials. Use less raw materials to make products. For example, offer smaller size hamburgers in the restaurant while charging the same prices as for bigger ones sold previously. Some airlines have saved millions of dollars each year by cutting back on the amount of chocolates or snacks that they offer on-board. However, this may negatively impact customer satisfaction.
- Find new cheaper suppliers. Change suppliers and buy from those who offer lower prices of raw materials. However, this can hinder the quality of final products.
- Lower packaging costs. Instead of using two or three different types of wrappers to package the product, the production department can replace excessive packaging with only one layer. Alternatively, the firm may ask some of its customers to come and pick up the products in person which will eliminate the need for any packaging to be used. This will allow the business to reduce packaging costs to zero.
- Cut direct labour costs:
- Reduce number of workers. Lowering staffing costs can be achieved by cutting the number of staff and getting remaining staff to do more for the same pay. However, this method can cause resentment and demotivation.
- Reduce workers’ pay. Lowering staffing costs can be achieved by cutting wages for production workers per piece produced or per hour. However, this method can cause motivation levels to fall reducing productivity and quality.
- Relocate production to countries with cheaper labor. Lowering staffing costs can be achieved by relocating production to low-labor-cost countries such as India, Vietnam, Indonesia, etc. However, this method can put quality at risk while communication problems with distant factories may also emerge.
- Use automation. Managers can seek more cost-effective production methods such as producing many products in one batch rather than making each product individually. By using assembly lines to mass produce products firms can lower Average Variable Cost (AVC), thereby helping to raise Contribution Per Unit made from selling each unit of output. While robots are very labor-saving, purchasing machinery will increase Expenses (Overheads) and workers need to be retrained to operate those new machines.
3. Decrease Expenses (Overheads):
- Cut rent:
- Negotiate for cheaper rent charges with the landlord. Trustworthy and creditable businesses may be able to negotiate lower rents or delay payment of rent to improve their cash flow. Also, signing longer lease contracts may help to get a better deal.
- Rent smaller premises. Very often businesses have extra space that is unused and redundant, but must be paid for on monthly or quarterly basis regardless whether its empty or used.
- Relocate. Another way to lower rent costs is to relocate the business head office outside the city center where the cost of land is much lower. Although relocation might not prove feasible when the business is already well-established in its current place as it could damage brand image.
- Cut management costs:
- Lower salaries for current managers. Similarly, to lowering wages for production workers, the business can either decrease salaries for its managers or reduce the number of managers who work in the business.
- Limit extravagant expenses. Some businesses no longer pay senior managers to fly first class or business class, but book economy class tickets instead, especially for shorter domestic routes.
- Hire cheaper managers. Also, this is an option, but this approach may have negative impact on how properly the business is being managed. Cheaper workforce is usually less knowledgeable, skilled and experienced.
- Delayer. One more method of cutting management costs could be to delayer the organization. But, fewer managers could reduce the efficient operation of the business.
- Cut marketing costs:
- Reduce promotion costs. Switching into cheaper or free below-the-line promotion methods such as slogans, social media marketing, trade shows, guerilla marketing, etc.
- Reduce sales expenses. However, cutting costs directly related to selling products could lead to sales falling by more than expenses.
- Reduce distribution costs. Negotiate preferential payment terms with creditors and suppliers, e.g. free transportation, free storage, free loading and unloading, etc. Alternatively, it might be possible to negotiate discounts for paying creditors on time, or delaying payment to improve working capital.
- Cut administrative costs:
- Careful examination of an organization’s expenses might reveal areas where costs can be cut without detrimental effects to the business. Hiring cheaper security firm or renegotiating all sorts of insurance can effectively lower the administrative expenses without actually negatively impacting the quality of products. Administration costs could also be lowered by combining jobs or employing fewer people to carry out such tasks. Lots of possibilities in this area. Other overheads that might be reduced are simple stationery items.
- Lower utility bills. Energy consumption such as heating and lighting could be adjusted, e.g. turning down the heating temperature during warmer days in winter, using less AC in the summer and turning off lights when not required. Also, keeping control over the amount of waste such as paper, stationery, water, etc.
