how to calculate operating profit margin
How to Calculate Operating Profit Margin
In very simple terms, operating profit margin is the profit that any business earns from its activities (operations). In this Buzzle article, you will learn how to calculate operating profit margin.
"The majority of earnings growth observed so far in the first quarter of 2014 has been a function of operating profit margins, as companies continue to operate with as few expenses as possible."
― Analysts at JP Morgan Asset ManagementThe Importance
The operating profit margin is very important because it is an indicator of the efficiency of the company. The higher this value, the better will be company run, i.e., the more profitable the business is. What is to be remembered here is that this ratio is calculated before the taxes and related expenses are incurred. It gives the credibility of the business in mathematical terms so that the owners are aware of how the business is running, what improvements can be made and what long-term plans can be made by the management, etc. In order to generate a sizable ratio, the company must operate efficiently to recover the costs of the product and operating expenses, as well as provide compensation for its owners. A higher value, thus, indicates a good cost control and increased sales. It also shows that the company has a low-cost operating model.
What Goes into the Calculation?
✦ Formula
Operating Profit Margin = Operating Income/Revenue
✦ Operating Income
It is also called earnings before interest and taxes (EBIT). It is the income that remains after all the operating costs and cost of goods sold are subtracted. The former includes overhead costs, like selling, administrative, and labor expenses. This value comes from the income statement of the business. This figure indicates how much the company/business has earned.
✦ Expenses Involved Explained
As mentioned earlier, the operating income involves the sum of all the costs put together. These costs do not involve the non-operating expenses; instead, they are subtracted from the final calculation while wanting to know the net profit margin.
(Note: Net profit margin and operating profit margin are different from each other.)
✦ The costs include- Profits and losses on assets
- Income taxes
- Interest expenses
- Interest income
Direct costs
These include operating expenses, depreciation, and amortization from gross income or revenues. These include:
- General expenses
- Selling expenses
- Administrative expenses
Direct selling expenses
- Credit
- Advertising
Indirect selling expenses
- Telephone charges
- Postal charges
Administrative expenses
- Salaries of staff
- Costs incurred on heat
- Electricity charges
Analysis
A business is usually considered stable if it can earn enough from its operations to support itself and the people involved in it. Thus, a higher operating margin ratio is better than a lower one, since it shows the financial strength of the company.
For example, a company with a ratio of 12% indicates that a profit of $0.12 is made on each dollar of sales before the interest and taxes. That means, for every dollar of income, 12 cents remain after the operating costs have been paid, which also indicates that 12 cents is all that remains to cover the non-operating costs.Example
Consider the income statement of a certain company, say ABC.
| Total Revenue | $1,000,000 |
| Cost of goods sold | $750,000 |
| Labor | $250,000 |
| General Expenses | $50,000 |
| Other Operating Costs | $100,000 |
Things to Remember
✦ A low ratio can indicate the strategy of pricing and the effect that competition has on margins.
✦ This ratio is not useful for a business that is suffering losses, i.e., in other words, a business that is losing a lot of money.