One of the methods used to measure a company's performance is to analyze the relationship between its revenue and the various expense categories that are delineated on the Income Statement. Prior to the 3^rd Ed. of the ETM, the discussion of this performance measurement method was mainly focused on Net Profit Margin, otherwise known in "finance-eze" as the "bottom line". However, in the 3^rd Ed. this discussion has been expanded to include three additional profit margin measures. Given this, I thought it might be useful to discuss each of the four profit margin ratios to help prepare you to answer potential exam questions that are designed to test your understanding of their definitions and more importantly, how each is differentiated from the others. So, let's start with Gross Profit Margin.

Gross Profit Margin (GPM)

Gross profit is the difference between Revenue and Cost of Goods Sold (COGS) and when it is divided by the Revenue and expressed as a percentage, it yields the GPM:

                GPM   =   Revenue - COGS / Revenue   =   Gross Profit   /   Revenue

GPM is a key measure of manufacturing performance because it represents the relationship  between the costs related to making the product and the revenue generated by the sale of that product. For example, when GPM is decreasing over time while revenue is increasing it " raises a red flag" that COGS might be in need of tighter cost control. Also, in many companies, GPM targets are used to determine the levels of compensation (salary and/or bonus) treatment for manufacturing management personnel.       

Operating Profit Margin (OPM)

Operating profit is the difference between Revenue and the total of COGS and Operating Expenses and when it is divided by Revenue and expressed as a percentage it yields OPM:

     OPM  =  Revenue  -  (COGS + Operating Expense) / Revenue  =  EBIT / Revenue

OPM is a key measure of overall operating performance because it represents the relationship between the total costs, of making and selling the product plus corporate overhead (i.e. administrative expenses), and the revenue generated by the sale of that product. Also, EBIT (Earnings before Interest and Taxes) is generally the same as OPM and for the purposes of the ETM and therefore for CTP exam questions, it is absolutely the same as OPM.

EBITDA Margin

This margin is essentially a hybrid performance measure because it combines EBIT, which is an "accounting profit" number, calculated in accordance with GAAP, with the "non-cash charges" of Depreciation and Amortization (see Blog 3, The Non-Cash Charge Enigma). By doing so, it restates EBIT and therefore Operating Profit on a cash flow basis, as follows:

 EBITDA Margin  =  ( EBIT + Depreciation & Amortization)  /  Revenue  =  EBITDA / Revenue

Net Profit Margin (NPM)

This margin, "the bottom line", reflects Operating Profit less all other expenses not related to the operations of the company such as, interest and taxes and plus other non-operating income items such as Comprehensive Income.

 Net Profit Margin   =   Revenue - (Operating Profit -/+ Non-Operating Items) / Revenue

                                 =   Net Income / Revenue

Simply stated, NPM measures the level of net profit generated on each dollar of revenue. For example, a company with a 10% NPM generates $.10 of net profit on every $1.00 of revenue.

-George Schilling, CTP