Profit vs. margin, being precise when it’s easy to be sloppy

Profit vs. margin, being precise when it's easy to be sloppy
Courtesy stevepb

Let’s take a quick detour through some financial vocabulary. Specifically, let’s draw a distinction between profit vs. margin.

What’s profit? It’s the dollar amount by which revenue exceeds costs. Profit and income are synonyms, when we talk about corporate financial performance. The only trick with profit is knowing which revenue stream, and which costs, we’re considering.

What’s margin? In the context of profitability, it’s the ratio of profit to the corresponding revenue.

That’s it. Profit is measured in dollars, like revenue and cost. Margin is unitless. It’s a ratio, often represented as a percentage.

Where’s the trouble? Profit and margin are often wrongly used interchangeably. It’s mildly sloppy. But even mild sloppiness can cause confusion. It’s better for us to keep these metrics straight from the beginning.

Let’s look at an example: Amazon

Below is the income statement from Amazon’s 2016 10-K report. We see Amazon’s revenue, cost, and profit for 2014, 2015, and 2016.

Amazon's income statements, 2014-2016
Amazon’s income statements, 2014-2016

The income statement tells us all about a company’s profitability. Let’s focus on Amazon’s 2016 results. We see $136.0 billion in total revenue, $4.2 billion in operating income, and $2.4 billion in net income.

Remember that profit and income mean the same thing in this context. You will often hear about operating profit, which is the same thing as operating income. For whatever reason, we almost always hear about net income, but only rarely net profit. I think that’s just an issue of convention.

Operating profit vs. operating margin

As we saw in the income statement above, Amazon reported an operating income, or operating profit, of $4.2 billion.

To compute operating margin, we simply divide operating profit by total revenue. We then see that Amazon had a 2016 operating margin of 3%.

What is operating profit? It’s total revenue minus operating costs. And which costs are operating costs? Basically everything except interest and taxes. That’s not exactly right, but it’s close.

Net income vs. net margin

Amazon reported a net income of $2.4 billion in 2016. If we divide net income by total revenue, we arrive at net margin. In 2016, Amazon’s net margin was 2%.

Net income is fully-burdened. In other words, it’s total revenue minus every reported cost. It’s a look at profitability, all-in, with no adjustments.

Gross profit vs. gross margin

Here’s one you won’t find on every income statement. Gross profit, or gross income, is sales revenue minus the cost of sales. Gross margin is gross profit divided by sales revenue.

We can see one important difference with gross profit. Operating profit and net income consider total revenue. Gross profit only considers sales revenue.

Gross profit and gross margin are relevant for companies that make and sell physical products. That’s what sales revenue is. It’s the revenue generated through the sale of products. Compare sales revenue to the revenue generated through the delivery of services, for example.

That’s why Amazon isn’t a great example for gross profit and gross margin. But Apple is. According to its 2016 10-K report, Apple generated $215.6 billion in sales, against $131.4 billion in cost of sales. Apple itself reports “gross margin” of $84.3 billion.

 

Who am I to say that Apple is wrong for reporting gross margin, instead of gross profit? Well, they’re clearly not wrong. They can call it whatever they’d like. Because they use the term in context, on an income statement, with the surrounding arithmetic, it’s clear what they mean.

But for you and me, when we’re talking casually, we need to be careful. The most rigorous use of “margin” is for a profitability ratio. The most rigorous use of “profit” or “income” is for a dollar amount, revenue in excess of cost. It’s a distinction that we would do well to respect.

A call for more precision when we talk about finance

I’m not saying we all have to become accountants. We don’t. But a little structure and precision in our word choice can go a long way.

I think vocabulary is one reason scientists and engineers stay away from finance. It can seem arcane, inaccessible, and haphazard. At a high level, though, it’s straight-forward. We can save ourselves, and each other, some headache by putting a little effort into learning the basic lingo.

Respect the difference between profit and margin. Develop and maintain a consistency in your vocabulary. I know these details can seem tedious, but rigor here will help you think and communicate more clearly. And stakeholders in your career will undoubtedly notice.

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