"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 Management
Operating profit margin can be defined in many ways. Basically, this term indicates the profitability for a company. In financial terms, it is the ratio of the income of a business venture to the revenue earned. It indicates how much revenue is left over after the expenses of the business ventures are subtracted, along with the cost of the goods sold. An important factor to remember here is that, this value is calculated on a before-tax basis, which is why is very important, as it brings to fore the financial viability of the basic operations of a business before any effect of taxes. The following article will explain to you how to calculate operating profit margin, along with its importance in the field of business.

The 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
Direct selling expenses
• Credit
Indirect selling expenses
• Telephone charges
• Postal charges
• Salaries of staff
• Costs incurred on heat
• Electricity charges

All of this is under the control of the management, which is why this ratio becomes even more vital. Conducting this analysis periodically gives the management an idea of how much the company makes on each dollar of sales, as well as cost control. The target of the management should, therefore, be on increasing the profit margin ratio by ensuring that as the revenue of the company grows, fixed costs tend towards becoming a smaller part of the total costs.

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

Operating profit margin = Operating income/Sales Revenue

= [(Cost of goods sold) - (Labor + General expenses + other operating costs)]/Revenue

= 750,000 - (250,000 + 50,000 + 100,000) / 1,000,000

= (750,000 - 400,000) / 1,000,000

= 350,000 / 1,000,000

= 0.35

Thus, company ABC has a ratio of 35%, which indicates that 65 cents on every dollar is used for paying variable costs, and 35 cents are used to cover the fixed costs.

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.

We hope you have, to an extent, understood the importance of operating margin ratio in a business. Remember that this ratio is very important for entrepreneurs to judge where exactly they stand in the market, and it gives them an idea of the financial position of the company. A optimum value indicates that the company is doing well, and efforts must be undertaken by the company's management personnel to maintain that position.
Saipriya Iyer
July 22, 2014