There are two common ways to estimate profitability in the business world, one is to consider the profit margin, and the other is to calculate Return on Investment (ROI). The profit margin percentage is calculated by breaking down the item price into cost and profit, whereas ROI focuses on the investment value of a product.
Return on investment (ROI) measures the gain or loss generated on an investment relative to the amount of money invested. ROI is usually expressed as a percentage and is typically used for personal financial decisions, to compare a company’s profitability or to compare the efficiency of different investments.
If you want to compare your performance to larger or smaller companies in your industry, ROI assists to measure how different divisions of a company perform compared to one another or whether buying more assets is making you more profitable.
ROI is calculated as- Profit / Investment (Cost)
Profit Margin is the amount by which revenue from sales exceeds costs in a business. The Lower your company keeps its costs or the larger the profits on each transaction, the higher the margin. If costs rise but the sales stay constant, the profit margin shrinks.
Profit margin is calculated as: Profit / Revenue (Sales)
Let’s understand both the concepts with below example,
Mr. A purchased goods worth Rs. 4,000, to sale the goods he incurred additional expenses of Rs. 500 towards fright and Rs. 500 towards administration and selling expenses. Mr. A sold goods at Rs. 10,000.
In the above case profit margin shall be calculated as,
Profit / Sales x 100 = (10,000 – 4,000 – 500 – 500) / 10,000 x 100 = 50%
Whereas Return on Investment shall be calculated as,
Profit / Investment x 100 = (10,000 – 4,000 – 500 – 500) / 4,000 x 100 = 125%
Comparing the two, one of the major differences between profit margin and ROI is that the profit margin can never exceed 100%, while ROI can. There are plus and minus to each way of calculating profit, but one is not inherently better than the other.
You can use both ROI and profit margin to measure your profitability. Neither one is “Better” in some absolute sense. It depends on what questions you want to be answered. If, for instance, you are pumping money into your business and you want to know the results of the added investment; ROI is the right metric. However, ROI won’t tell you, how much profit your company brings in or whether you have enough cash flow to meet monthly expenses.
If your primary concern is the profit margin, for example, if your profits are going up and your costs are also going up faster, your profit margin is going to drop. That’s a warning sign that your business strategy has a problem. Even if the profits are good overall, you may discover individual product lines or services have unpleasantly low margins, a sign you might be better off without them.
Simply knowing how much money you made last year isn't a good enough guide to how well your business is doing. Some companies generate lots of profits because of their size. Other businesses increase profits but spend too much money to do so. Good metrics, such as your return on investment and profit margin can give you a better sense of your company's performance.
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