How to Determine Operating Profit Margins

Calculating Operating Profit Margin

The operating profit margin is the ratio you get when you divide operating income by total sales revenue. It is a type of profitability ratio known as the margin ratio.

The Formula Used to Calculate Operating Profit Margin

To calculate your company’s operating profit margin, divide operating income by total sales revenue:

Operating Profit Margin = Operating Income / Total Sales Revenue

In some cases, operating income is referred to as earnings before interest and taxes (EBIT). Operating income or EBIT is the total income remaining on the income statement after subtracting operating costs and overhead expenses, such as selling costs, administrative expenses, and the cost of goods sold. You can calculate it as follows:

Operating Income (EBIT) = Gross Income – (Operating Expenses + Depreciation and Amortization Expenses)

You will also need to find your company’s total sales revenue before you can determine the operating profit margin. Finding total net sales doesn’t require any calculation because the sales listed on the income statement are net sales. If this figure is not available, you can calculate net revenue by taking the company’s gross sales and subtracting sales returns, allowances for damaged goods, and any discounts given.

Example of Calculating Operating Profit Margin

Suppose you have a small business and have a gross income of $250,000 for the previous 12-month period – this is also your total sales revenue. The cost of goods sold and operating expenses for the same time period equal $175,000. First, we need to calculate the operating income (or EBIT), which is the gross income or total net sales revenue minus operating expenses and the cost of goods sold:

250,000 – 175,000 = $75,000

Now, we can calculate the operating profit margin, which is operating income ($75,000) divided by total net sales revenue ($250,000).

$75,000 / $250,000 = 0.3

Your operating profit margin is 0.3 or 30%. For every dollar in sales, your company earns 30 cents in profit.

Why is Operating Profit Margin Important?

The operating profit margin is a useful indicator of your company’s financial health. It can be used to compare your company to its competitors or similar companies.

For example, a company with a margin of 8% and an average of its competitors over 10% may be at greater financial risk than another company with the same margin and an average of its competitors at 7%.

You can also compare one company’s operating profit margin across several fiscal years or quarters to measure whether the company is becoming more efficient and profitable over time.

Companies with high operating profit margins can generally:

• Cover their fixed costs and debt interest
• Survive economic downturns
• Compete better because they can offer lower prices than competitors

The operating profit margin provides a way to assess how successful a company’s business model is compared to its competitors or across its industry. It serves as a general indicator of the company’s efficiency.

Limitations of Operating Profit Margin

While the operating profit margin is valuable, it has three main limitations:

• It should not be used as a standalone calculation: The ratio is valuable when compared to other profitability ratios, either over time or among companies.
• Incorrect results can occur: Using inaccurate accounting data or financial statements prepared with inconsistent accounting standards can lead to incorrect results.
• It is not an indicator of the company’s quality or future: It does not take into account any qualitative information about the company, nor does it give any indication of the likelihood of future outcomes.

The operating profit margin is one of many tools that can be used to assess the health of your company’s finances. It is a valuable data point, but it should not be the only number used to determine whether your company is profitable and competitive in the long term.

Questions

Frequently Asked Questions (FAQs)

What does the operating profit margin tell you?

The operating profit margin gives you a little insight into the financial health of your company. The higher the margin, the more profitable your company is. The lower the margin, the less profitable your company is. You can use it to compare your company with other companies, but there are some limitations, such as it does not provide any indication of future profitability.

What is operating profit?

Operating profit is the ratio you get when you divide operating income by total sales revenue. If it’s positive, it will be higher than 0. If it’s 0, the company is operating without profit. If it’s a negative number, the company is operating at a loss.

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Sources

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editing process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.

U.S. Securities and Exchange Commission. “Beginner’s Guide to Financial Statements.” North Carolina Archives. “Introduction to Interpreting Hospital Margins.”

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