Operating Profit Margin

Operating Profit Margin is the profitability ratio used to determine the percentage of the profit the company generates from its operations before deducting the taxes and the interest and is calculated by dividing the company's operating profit by its net sales.

It is different across companies and sectors and can be used as a good benchmark for comparing the financial performance of one company with its peers. Based on this metric, it is possible to analyse the business's current profitability and future potential.

A good operating profit margin is a valuable ratio to measure the profit-earning capacity of an entity. The margin shows how much revenue the business leaves after paying off all the expenses.

Analysts, creditors and investors continuously use this metric to understand the business performance. It helps them to interpret how much value addition the entity is possibly making to the capital invested with them. This gives them the idea whether investing in such companies will ensure return. It is also useful for lenders because profitability is a most important criteria to judge the loan repayment capacity. Lenders will give loans  based on the creditworthiness of the enterprise.

Investors avidly use it because the investors can get to know how much a firm earns in terms of operating profit. Here's the formula of operating profit margin ratio –

Operating Margin Formula = Operating Profit/Net Sales * 100

In the above formula, we have two critical components.

The first component is the operating profit.

• We get to the operating profit by deducting the cost of goods sold and other expenses from the net sales. And if you look at the income statement of a company, you would be able to discover the operating earnings quite well. The specialty of operating income is that it doesn't include income and expenses except those related to the operating profit.
• The second component in the above operating margin formula is net sales. We start the income statement with the gross sales. Gross sales are the total revenue earned by the company. But to find out the net sales, we need to deduct any sales return or sales discount from the gross sales.

And in the operating profit margin ratio above, we compare the operating profit and the net sales to determine the proportion.

Let's take some simple examples to illustrate the formula.

Example#1

Here're the few details of the income statement of YOU Matter Inc. –

• Gross Sales - $564,000
• Sales Return - $54,000
• Cost of Goods Sold - $2,40,000
• Labour Expenses - $43,000
• General & Administration Expenses - $57,000

Find out the operating profit margin of YOU Matter Inc.

In this example, first, we need to find the net sales of YOU Matter Inc.

• Gross sales are $564,000, and the sales return is $54,000.
• Then the net sales would be = (Gross Sales – Sales Return) = ($564,000 - $54,000) = $510,000.

We need to deduct the cost of goods sold from net sales to find out the gross profit.

• Then the gross profit would be = (Net Sales – Cost of Goods Sold) = ($510,000 - $240,000) = $270,000.

Now we will deduct the operating expenses from gross profit to determine the operating profit.

• The operating profit would be = (Gross profit – Labour expenses – General and Administration expenses) = ($270,000 - $43,000 - $57,000) = $170,000

Using the operating margin formula, we get –

• Operating Profit Margin formula = Operating Profit / Net Sales * 100
• Or, Operating Margin = $170,000 / $510,000 * 100 = 1/3 * 100 = 33.33%.

Thus, from the above example it is clear how to calculate the operating profit margin rate.

Example #2

Below is the snapshot of Colgate's Income Statement from 2007 to 2015. This will also show how to calculate the operating profit margin rate.

• Colgate's Operating Profit = EBIT / Net Sales.
• Historically, as per the operating profit margin analysis, Colgate's Operating Profit has remained in the range of 20%-23%

However, in 2015, Colgate's EBIT Margin decreased significantly to 17.4%. This was primarily due to a change in accounting terms for the CP Venezuela entity (as seen below)

Many firms emphasize net profit. The net profit results from the whole income and expenses rendered by a company. But if the net profit margin is higher, it doesn't ensure the efficiency of a company. Rather, it may hide the actual profit generated by the operating efforts of the company.

That's why investors should look at operating profit. Since a good operating profit margin helps determine how much profit the companies have made from their operations, it ensures efficiency and profitability. And that's the reason – it is one of the most significant profitability ratios of all.

While finding out the profit margin, the investors should look at gross profit margin and net profit margin; along with that, they should look for the operating profit margin analysis, which will surely bridge the gap in understanding how a company is doing operationally.

Let us now do the same example of the operating margin formula in Excel. This is very simple.

First, you need to find the Net Sales and Gross Profit, and then you will need to deduct the operating expenses from gross profit to find out the operating profit. Then by using the operating Margin formula, we will calculate Operating Profit Margin.

You can easily calculate the operating margin ratio in the template provided.

First, we need to find the net sales of YOU Matter Inc.

To find the gross profit, we need to deduct the cost of goods sold from net sales.

Now we will deduct the operating expenses from gross profit to determine the operating profit.

Now, By using the operating profit margin formula, we get –

Operating profit margin includes the overhead expense whereas gross profit margin includes only the direct expenses. However, the basic differences between them are as follows: