How to Calculate and Analyze the Operating Profit Margin Ratio
In order to survive the ever-fluctuating modern market, businesses must be able to sustain at least the minimal profit to meet financial obligations. Any excess revenue can then go towards investment, expansion plans, or savings for unexpected costs.
However, owners must be able to actively monitor their profits to ensure they do not dip to dangerous levels. By calculating and tracking the operating profit margin ratio, organizations can improve their spending, customer, and operational management.
What is the Operating Profit Margin?
The operating profit margin ratio measures the profit a company generates from each dollar made from sales, after all of the operational costs are deducted but before taxes or interest is subtracted. This margin is also referred to as the operating margin ratio, return on sales, and earnings before interest and tax (EBIT) margin.
The margin is often represented as a ratio or percentage calculated by dividing the profit by the total revenue. It is used by many kinds of businesses to determine the profitability of each product line. However, the metric is used differently across various industries. Some companies use it to set financial targets, while others use it to gauge their performance against competitors.
It can be difficult to differentiate the operating profit margin from other financial values, such as net profit, gross profit, and profit margins. However, they each measure a unique financial performance.
- Net Profit refers to the final income after all costs within the accounting period have been deducted, whereas the operating profit margin does not subtract taxes nor interest.
- Gross Profit only considers how direct operational costs impact profitability, whereas operating profit margin also takes overhead expenses into account.
- Profit Margins, like gross profit, do not consider indirect production costs. However, these margins are unique to each product, whereas the gross profit measures a company's profitability as a whole.
How to Calculate the Operating Profit Margin
The operating profit margin equation is a relatively simple formula.
Operating Profit Margin = Operating Income / Sales Revenue
However, some financial statements do not present this value. Instead, they outline the gross income and expense report. Many financial documents also refer to the operating income as EBIT. In this case, management can calculate their operating profit margin by
Operating Income (EBIT) = Gross Income Expenses
1. To find the operating income, businesses need to subtract all of their expenses from their gross income. Typical expenses include the cost of goods sold (COGS), operational expenses, depreciation, and overhead costs.
2. Determine the company's net sales revenue. This will be listed on the income statements as net sales. However, if this value is not provided, managers can calculate the net sales by subtracting the sales returns by the gross sales, as well as any discounts.
3. The operating revenue from step one is divided by the net sales found in step two to calculate the operating profit margin.
For example, a business has gross sales of $8 million at the end of the year. Their COGS and operating costs totaled $2.3 million, making their operating profit margin .29 or 29%.
$2.3 million / $8 million = .2875
How to Evaluate the Operating Profit Margin
Businesses need to analyze their operating profit margin intermittently over a long period and compare it to the average of their overall industry. The higher the profit margin, the more money businesses can keep from their income, regardless of their variable costs.
When the operating profit margin fluctuates, companies must determine the root cause to prevent any adverse effects.
Increase in Operating Profit Margin & Decrease in Gross Profit
When the operating profit margin increases while the gross profit margin decreases, companies may be experiencing-
- Decreased non-operational overheads in proportion to sales, as the fixed expenses were spread out wider amongst more units.
- Reduced falling gross profit margin by decreasing staffing needs and other unnecessary expenses.
Increase in Operating Profit Margin & Increase in Gross Profit
On the other hand, when the operating profit margin and gross profit margin increases, organizations are more than likely experiencing
- More sales, decreasing the ratio between the production and non-production costs.
Decrease in Operating Profit Margin & Increase in Gross Profit
When the operating profit margin is decreasing while the gross profit margin is increasing there is typically
- Increased sales in proportion to general expenses, such as administrative, marketing, and payroll costs. This is often due to expansion or new market penetration.
Decrease in Operating Profit Margin & Decrease in Gross Profit
Lastly, when both the operating profit and gross profit margins are declining, companies may have
- Operational efficiencies, such as poor productivity, cost reduction techniques, and staffing.
- Increased competition as new, most cost-effective businesses entered their market and threatened their customer loyalty.
Most businesses want to maintain an operating profit margin of at least 15% to ensure they can supplement unexpected costs.
The operating profit margin is a critical value that every business must consider, regardless if they are just starting out or established. Not only do high margins represent profitability, but they also indicate that the company is able to withstand a competitive market and changes to the economic state.
- Guide to Product Portfolio Management For Businesses
- Guide to Product Portfolio Management For Businesses
- What Is the BCG Growth Matrix? Overview For Businesses
- Inventory Analytics Definition, Benefits, and Metrics to Track
- How to Calculate and Analyze the Operating Profit Margin Ratio
- How to Perform a Product Analysis 5 Steps
- How to Conduct a Target Market Analysis 7 Steps
- What is Product Innovation? 5 Pillars to Know