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A Complete Understanding of the Operating Profit Margin

by Jules Nguyen
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A Complete Understanding of the Operating Profit Margin

Your company is probably dealing with a number of stressors right now, such as dealing with cash flow management, keeping customers satisfied, repaying debts, and finding ways to increase profit.

Managing and growing your operating profit margins are key to your company’s financial success when it comes to enhancing overall profitability. It’s also an important accounting strategy for small businesses that want to be successful both online and offline. 

What is the operating profit margin?

A company’s operating profit margin (OPM) shows how much profit it generates on each dollar of sales after paying for variable costs of production, like wages and raw materials, but before deducting interest and tax.

It is computed by dividing a company’s net sales by its operating income. This ratio is significant since it indicates how well your company’s operations contribute to its profitability.

So, what is a good operating profit margin? In general, the higher ratios, the better. It indicates that the company is efficient in its operations and is good at converting revenues into profits.

Besides, it differs across industries, and it is often used as a metric for benchmarking one company against similar companies within the same industry. It can also show the top performers in one industry and indicate the need for more research to be done to find out why one company is doing better or worse than its peers.

Why is operating profit margin important?

The operating profit margin is often used to evaluate how well a business is running and how efficiently it can create profits. This metric, if changes significantly, is a sign of risks. Therefore, the ratio is monitored over time to make sure the business doesn’t have trouble sustaining enough margins.

In other words, this metric is a way to measure how much profit the company makes from its core operations in comparison to total sales.

OPM, expressed as a percentage, represents how much earnings are made from operations for every $1 in sales after direct expenses of obtaining those revenues are taken into account. With higher margins, more of every dollar in sales is preserved as profit.

Operating profit margin highlight Besides, a company’s operating profit margin would reflect how well it is managed since operating expenses like renting, salaries, and equipment leases are variable costs, not fixed costs – direct manufacturing expenses such as the cost of raw materials used to manufacture the company’s goods. 

Therefore, it is useful in the budgeting process since it displays the percentage of revenues available to pay non-operating costs. It is a useful performance metric for tracking the efficacy of budgeting initiatives and cost-cutting measures.

Although it cannot be depended on for monitoring expenditure reduction, it is a solid sign that business processes are functioning smoothly or that budgeting together with operating initiatives are producing favorable outcomes.

What’s more, this is an exceptionally beneficial statistic for an acquirer since this party is not concerned with the target company’s financial structure (which will likely change as a result of the acquisition). It is primarily concerned with the company’s fundamental capacity to generate earnings.

For those reasons stated above, your business should definitely measure and track this metric on a regular basis.

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How to calculate the operating profit margin?

To figure out your company’s operating profit margin ratio, you will have to divide its operating profit by net sales revenue:

Operating profit margin calculation

Simply put, a 15% margin is $0.15 in profit for every dollar of revenue.

In certain circumstances, “operational profit” is referred to as “Earnings Before Income and Taxes” (EBIT). Operating profit, or EBIT, is simply calculated by taking revenue and subtracting the cost of goods sold (COGS), regular selling and administrative costs, and other expenses. 

Still, you should be aware that some expenses are not included in the calculation of the operating profit are interest expense, income taxes, interest income, and any gain or loss on asset sales.

The calculation of operating profit

Before you can calculate your OPM, you must first estimate your company’s net sales revenue. Because the sales reflected on your income statement are net sales revenue, so you don’t have to do any math to find out its value. 

If that figure is unavailable, net sales revenue can be calculated by taking the company’s gross sales and deducting sales returns, allowances for damaged items, and any discounts provided.

Example:

Let’s say that in the last 12 months, your business made $2 million in gross sales, which is also your net sales revenue. The cost of goods sold is $70,000, while the administrative cost is $500,000.

First, we need to figure out the operating profit (or EBIT), which is equal to your gross income or net sales revenue minus your operating costs and the cost of goods sold:

  • Operating profit = $2 mil – ($700,000 + $500,000) = $800,000

Now we can figure out the OPM ratio by taking operating profit ($800,000) divided by your net sales revenue ($2 million).

  • Operating profit margin = $800,000 / $2,000,000 = 0.4

Your OPM is 0.4, which is 40% meaning your business makes 40 cents in profit for every dollar of sales.

Similarly, if your brand could negotiate better rates with its suppliers, lowering its COGS to $500,000, it would experience an increase in its operating margin to 50%, or $0.5 operating profit for every $1 of sales.

Limitations of the operating profit margin

While this margin ratio is useful, it has three major limitations:

  • It should not be used as an independent calculation: When compared to other profit margin ratios over time or between firms, the ratio has value.
  • False results can happen: Using improper accounting data or inconsistent financial statements produced by different accounting standards might lead to inaccurate outcomes.
  • It does not represent a company’s quality or future: It does not take into account any qualitative information about a company and provides no indication of the likelihood of future results.

Although this is an important financial health metric, it should not be the sole one used to decide if your company is profitable and competitive in the long run.

Furthermore, the operating margin should only be used to compare brands in the same industry, ideally, with similar business structures and yearly sales. Companies in various industries with different business models have vastly varied operating margins, making comparisons pointless.

A group are working on operating profit

Besides, you should also remember that the operating margin does not account for all of your company’s expenses. For example, interest income and costs are not included in operational income but are included in operating cash flow.

Additionally, items of income or loss from changes in foreign exchange rates are taken out of the income statement further down.

How can businesses improve their operating profit margin?

When a company’s operating margin surpasses the industry average, it is considered to have a competitive advantage. It also means that it is more successful than other businesses with similar operations. 

While average margins vary greatly among industries, businesses can usually gain a competitive edge in general by boosting sales or decreasing expenses, — or both.

Increasing sales, frequently necessitate spending more money on many things, which means higher expenses. Cutting too many expenses, on the other hand, can potentially result in unfavorable results, such as the loss of qualified staff, the use of cheaper materials, or other quality losses. Reduced advertising spending may also hurt sales.

For many companies, the greatest way to cut manufacturing costs without losing quality is to expand their business. The concept of economies of scale refers to the belief that larger firms are more lucrative. 

Because of a huge company’s higher level of production, the cost of each item is decreased in a variety of ways. Take an example, wholesalers frequently provide discounts on bulk purchases of raw materials.

💡 Further material

Here’s a short video that shows how to figure out the ratio and explains why it’s important when doing financial analysis; you can watch it for the ultimate understanding after reading our blog.

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In short

You can figure out the operating profit margin regardless of the accounting technique you choose. 

Calculating operational margin provides business owners with an additional measure of profitability and can highlight trouble spots, making it a crucial assessment for all business owners.

Read more about the 5 Most Common Mistakes When Calculating The Profit Margin to avoid mistakes in profit calculating and be more careful with this metric.

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