Understanding Sales Margin- Why is It Important?
Businesses are created to make a profit. Therefore, business owners are concerned about how much profit they are making. Is the company making a profit? The sales margin is an important tool to answer this question.
This article discusses the concept of sales margin and why understanding sales margin is important in running a business.
What is it? Understanding Sales Margin to Determine Profitability
The sales margin is the profit made in every sale transaction. This is used to calculate profitability in the individual sale transaction level instead of profitability in general. The sales margin will tell if your products are making profits or losses. Further sales margin can reveal what a particular product is generating the most profit out of all your product lines.
You compute sales margin by:
Sales Margin = Net Sales – Cost of Product Sold – Direct Selling Cost
The net sale is the selling price of the product, less sales discounts, and allowances. The cost of products sold is the total direct cost of producing the goods or the direct cost of bringing the product to the market.
The sales margin can also be analyzed as a percentage or ratio. To compute, divide the sales margin by the net sales.
Sales Margin Ratio = Sales Margin / Net Sales
Let’s take an example. You are selling wooden picture frames for a net price of Php 75. It costs Php 45 to make each frame, and the agent gets Php 10 for every frame sold. The sales margin would be Php 20. That is computed as follows.
Sales Margin = 75 – 45 – 10 = 20
This simply means that the wooden frame generates Php 20 profit for every sale transaction. So if the wooden frames sell 20,000 pieces in a month, it makes Php 400,000 of profit. Now, let’s compute for the sales margin ratio.
Sales Margin Ratio = 20 / 75 = 26.7%
Directly comparing sales margin might be misleading as you have to weigh other factors to make relevant comparisons. You use the sales margin ratio when comparing the profitability of products. This percentage would make more sense if you compare it with the sales margin ratio of another product.
With the same problem above, let’s assume further that the metal frames have a sales margin ratio of 25% and the collage frames have 10%. If you compare the products using the sales margin ratio, you can say that your wooden frames are your most profitable product because they have the highest sales margin ratio.
Sales margin computations vary in every company and industry. As long as you understand the concept and what it implies, then you’re good. So what benefits does understanding sales margin provide?
Assessing if Products Are Profitable
The primary purpose of the sales margin is to determine the profits made by every product. Further, it is important to compute the sales margin because it is generally the starting point to reach healthy profits on a company-wide scale.
When you have a good sales margin, you are in good standing to secure a good operating income and net income. Therefore, in computing your sales margin, you can also assess if you are capable of being profitable as a whole.
However, many other factors affect profitability, whether on a small scale or big scale. Certain factors cannot be translated into amounts and be considered in the formula. Pricing strategy, competition, economy, and many others will affect product profitability. It is vital to remember this when computing the sales margin.
Identifying Pricing Problems
Using the profit margin can reveal if products are making profits or losses. If products are generating losses, this might be an indication of pricing problems. You may need to change your pricing strategy or the costing of your products. There are many different pricing and costing methods you can use to better represent your business and that would also make your products more profitable.
Are you having problems computing your sales margin? Don’t know how to interpret accounting ratios or percentages? 3E Accounting is here to assist you in all your financial needs. Employing only proficient Philippine accounting experts, we can help you resolve your issues and confusion. Contact us and let’s talk about how to better manage your financials.