Operating profit divided by total revenue, expressed as a percentage
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Operating Profit Margin is a profitability or performance ratio that reflects the percentage of profit a company produces from its operations before subtracting taxes and interest charges. It is calculated by dividing the operating profit by total revenue and expressing it as a percentage. The margin is also known as EBIT (Earnings Before Interest and Tax)Margin.
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Operating Profit Margin differs across industries and is often used as a metric for benchmarking one company against similar companies within the same industry. It can reveal the top performers within an industry and indicate the need for further research regarding why a particular company is outperforming or falling behind its peers.
How to Calculate Operating Profit Margin?
Operating profit is calculated by subtracting all COGS, depreciation and amortization, and all relevant operating expenses from total revenues. Operating expenses include a company’s expenses beyond direct production costs, such things as salaries and benefits, rent and related overhead expenses, research and development costs, etc. The operating profit margin calculation is the percentage of operating profit derived from total revenue. For example, a 15% operating profit margin is equal to $0.15 operating profit for every $1 of revenue.
How to Use Operating Profit Margin?
Operating Profit Margin differs from Net Profit Margin as a measure of a company’s ability to be profitable. The difference is that the former is based solely on its operations by excluding the financing cost of interest payments and taxes.
An example of how this profit metric can be used is the situation of an acquirer considering a leveraged buyout. When the acquirer is analyzing the target company, they would be looking at potential improvements that they can bring into the operations.
The operating profit margin provides an insight into how well the target company performs in comparison to its peers, in particular, how efficiently a company manages its expenses so as to maximize profitability. The omission of interest and taxes is helpful because a leveraged buyout would inject a company with completely new debt, which would then make historical interest expense irrelevant.
A company’s operating profit margin is indicative of how well it is managed because operating expenses such as salaries, rent, and equipment leases are variable costsrather than fixed expenses. A company may have little control over direct production costs, such as the cost of raw materials required to produce the company’s products.
However, the company’s management has a great deal of discretion in areas such as how much they choose to spend on office rent, equipment, and staffing. Therefore, a company’s operating profit margin is usually seen as a superior indicator of the strength of a company’s management team, as compared to gross or net profit margin.
Video Explanation of Operating Profit Margin
Below is a short video that explains how to calculate the ratio and why it’s important when performing financial analysis.
Operating Profit Margin Template
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Limitations of Using the Operating Profit Margin Ratio
As in any part of financial analysis, any number of interest requires additional research to understand the reasons behind the number. Discrepancies in operating profit margin between peers can be attributed to a variety of factors. For instance, a company pursuing an outsourcing strategy may report a different profit margin than a company that produces in-house.
In comparing companies, the method of depreciation may yield changes in operating profit margin. A company using a double-declining balance depreciation method may report lower profit margins that increase over time, even if no change in efficiency occurs. A company using a straight-line depreciation method would see a constant margin unless some other factor changes as well.
A general rule is to hold factors such as geography, company size, industry, and business model constant when using operating profit margin as a comparison analytic between peers. It is also useful to consider other profitability metrics alongside it, such as Gross Profit Margin or Net Profit Margin, as well as other financial metrics, such as leverage, efficiency, and market value ratios.
You can advance your expertise in financial analysis of companies’ money management and profitability by learning about the other aspects of corporate finance that are detailed in the articles listed below.
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FAQs
The operating profit margin is calculated by subtracting the cost of goods sold and selling, general and administrative expenses (also called operating expenses or SG&A) from net sales. That number is divided by net sales, then multiplied by 100%.
What is considered a good operating profit margin? ›
Generally, a 10% operating profit margin is considered an average performance, and a 20% margin is excellent. It's also important to pay attention to the level of interest payments from a company's debt.
How do you calculate operating profit margin (%)? ›
Operating Profit Margin is a profitability or performance ratio that reflects the percentage of profit a company produces from its operations before subtracting taxes and interest charges. It is calculated by dividing the operating profit by total revenue and expressing it as a percentage.
How do you comment on operating profit margin ratio? ›
If operating profit margin is low, it is an indicator that operating costs are too high, non-operating costs are too high, or both are too high. The ratio is a measurement of profitability, therefore when the resulting metric is low it is an indicator that profitability is too low.
How do you solve for operating profit? ›
Operating profit is calculated by taking revenue and then subtracting the cost of goods sold, operating expenses, depreciation, and amortization.
What is the operating profit margin quizlet? ›
- It is used to measure a company's pricing strategy and operating efficiency. - It gives an idea of how much a company makes (before interest and taxes) on each pound of sales. - A high or increasing operating margin is preferred.
What does a 20% operating profit margin mean? ›
This implies that for every INR 100 of revenue generated, the company retains INR 20 as operating profit after covering its operational costs. The 20% operating margin indicates a relatively efficient operation, suggesting that the company effectively manages its production, distribution, and administrative expenses.
How do you interpret operating margin? ›
Operating margin is the percentage of revenue that a company generates that can be used to pay the company's investors (both equity investors and debt investors) and the company's taxes. It is a key measure in analyzing a stock's value. Other things being equal, the higher the operating margin, the better.
What is a reasonable profit margin for a small business? ›
What's a good profit margin for a small business? Although profit margin varies by industry, 7 to 10% is a healthy profit margin for most small businesses. Some companies, like retail and food, can be financially stable with lower profit margin because they have naturally high overhead.
What factors affect operating profit margin? ›
Two simple levers drive operating profit and margins—sales and expenses. A business can increase sales by raising prices or increasing output. Alternatively, it can reduce the cost of goods sold (COGS) or selling, general, and administrative expenses (SG&A).
A low or negative operating margin may indicate pricing pressure or inefficiencies within the company's cost structure. The assessment of a good or bad operating margin should consider industry benchmarks, historical trends, and the company's own performance over time.
What is an example of operating profit? ›
Example of Operating Profit
10,00,000 from the sales of computer hardware. The company incurred operating expenses of Rs. 6,00,000, which include the cost of goods sold, salaries, rent, utilities, and other expenses related to production, administration, and selling activities.
What is a healthy profit margin? ›
As a rule of thumb, 5% is a low margin, 10% is a healthy margin, and 20% is a high margin.
What is a good operating ratio? ›
OER is used for comparing the expenses of similar properties. An investor should look for red flags, such as higher maintenance expenses, operating income, or utilities that may deter them from purchasing a specific property. The ideal OER is between 60% and 80% (although the lower it is, the better).
What is the difference between operating margin and profit margin? ›
Gross profit margin includes the direct costs involved in production, while operating profit margin accounts for operating expenses like overhead. Both metrics are important in assessing the financial health of a company.
What is the formula for operating margin ratio? ›
Operating margin, also known as return on sales, is an important profitability ratio measuring revenue after covering the operating expenses of a business. Operating margin is calculated by dividing operating income by revenue.
What does the operating profit margin rate indicate? ›
The operating profit margin informs both business owners and investors how efficiently a company can convert a dollar of revenue into a dollar of profit after accounting for all the expenses required to run the business.
What is the formula for revenue? ›
Revenue (sometimes referred to as sales revenue) is the amount of gross income produced through sales of products or services. A simple way to solve for revenue is by multiplying the number of sales and the sales price or average service price (Revenue = Sales x Average Price of Service or Sales Price).
What is the formula for operating ratio? ›
Operating ratio formula
Here is the formula to calculate an operating ratio:Operating ratio = (operating expenses + cost of goods sold) / net salesYou may find several of these on income reports for the company, especially operating expenses and cost of goods.
