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What’s it: Operating profit margin is a profitability ratio to measure the percentage of profit a company generates from its core business. It tells us how much profit the company makes after paying operating xpenses but before paying interest, taxes, and other non-operating expenses. We calculate it by dividing operating profit by revenue. Also known as operating margin or operating ratio.
A higher margin is preferred because more money is left to pay for non-operating expenses. In addition, it shows the company is efficient in managing its core business, thus, posting lower costs to generate revenue. On the other hand, a low margin is less desirable.
Why is operating profit margin important?
Operating margin is important to show how successful the company is in generating profits from its core business. We need to compare it to competitors or the industry average to understand how successful the company is relative to competitors.
Companies in the same industry face the same threats and opportunities in the business environment. And a higher margin sends a positive message, indicating better internal performance than competitors in dealing with the business environment.
Analysts use this ratio as a metric to measure how efficient a company’s core operations are. It considers direct costs, such as the cost of goods sold, and indirect costs, such as selling, general and administrative expenses.
The cost of goods sold represents variable costs, fluctuating with the production volume. Meanwhile, selling, general, and administrative expenses are generally fixed costs, which must be incurred by the company even though it is not producing or generating revenue.
So, how efficient the company’s core business is, depends on the management’s ability to manage those costs. When the company can reduce these costs, operating margins will increase, ceteris paribus.
Then, the margin also reveals the company’s success in competing in the market. A competitive position allows a company to fetch higher margins by operating on a lower cost structure or developing differentiation to charge higher prices than the industry average.
Lastly, investors look at this ratio to evaluate whether the company generates earnings mostly from its core operations or from other sources, such as investments. And, they like it when the core business is profitable.
How to calculate operating profit margin?
We calculate the operating margin by dividing the operating profit by revenue, expressed as a percentage. Here is the formula:
- Operating profit margin = Operating profit/Revenue
Some companies present operating profit (or operating income) as a separate account on the income statement, but others may not. So if we don’t find it, we can calculate it manually.
Operating profit represents the remaining revenue after the company has paid expenses such as cost of goods sold (COGS), selling expenses, general expenses, and administrative expenses, including depreciation and amortization expenses. Long story short, it equals gross profit minus operating costs.
- Operating profit = Gross profit – COGS – Operating expenses
- Operating profit = Revenue – COGS – Selling expenses – General and administrative expenses
Now, let’s take a simple example. A company reports revenue of $4 million. The company incurred a COGS of $800,000 and operating expenses of $1 million to generate the revenue.
In this example, the company’s gross profit is $3.2 million = $4 million – $800,000. Meanwhile, its operating profit was $2.2 million = $3.2 million – $1 million. Thus, the operating margin is 55% = $2.2 million / $4 million.
Operating margins can increase if the company charges higher prices to earn more revenue while maintaining existing costs. Alternatively, the company could do so by pressing down COGS and operating expenses, such as automating manual work, improving economies of scale, and negotiating lower prices with suppliers.
How to interpret operating profit margin?
Operating margin gauges the profitability of a company’s core business. Specifically, it shows what percentage of profit the company earns from its core business. The higher the percentage, the more favorable it is. It indicates the company is managing its core business profitably.
Conversely, a lower ratio is not preferred. And investors and creditors will view it pessimistically.
However, to measure how well a company’s operating margin is, we must compare it to competitors or the industry average. Because the ratio can vary across industries, comparing it to companies in different industries can be misleading. Therefore, we must isolate our analysis by comparing it with peer companies in the same industry. If it’s higher, it’s better.
Lastly, the increase in the operating margin over time is a good sign. The company improves its efficiency. And, it can be achieved by strengthening competitiveness and developing more effective marketing. Using resources more efficiently and better pricing are other ways to achieve this.
Operating profit margin vs. gross profit margin
The operating margin is more complete and accurate than the gross profit margin in measuring the company’s profitability performance. This is because it considers not only direct costs but also indirect costs. In contrast, gross profit margin only takes into account the direct costs.
The gross margin is equal to gross profit divided by revenue. To get gross profit, we subtract the cost of goods sold from revenue.
In the analysis, we can compare the two profitability margins together to see how successfully the company controls operating costs. For example, if the operating margin increases higher than the gross margin, the company successfully controls operating costs. The opposite condition indicates problems in improving efficiency and lowering operating costs.
