What is the Operating Profit Margin?

The operating profit margin is the earnings that a business generates from its operating activities. It reveals the financial viability of the core operations of a business before any extraneous financial or tax-related effects. As such, it is one of the better measures of how well a management team is running a business. This is one of the three margin-related measurements that can be applied to an organization’s income statement. The other ratios are the gross profit margin and the net profit margin.

How to Calculate the Operating Profit Margin

The basic calculation of the operating profit margin is to subtract the cost of goods sold and all selling and administrative expenses from net sales. The formula is as follows:

Net sales - Cost of goods sold (such as direct materials, direct labor, and overhead) - Selling and administrative expenses

= Operating profit or loss

The operating profit is then divided by net sales to arrive at the operating profit margin percentage.

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The expenses included in the calculation of the operating profit margin are comprised of both variable expenses and fixed expenses. This calculation does not necessarily result in a subtotal for a contribution margin (which is derived from revenues minus variable expenses), with fixed costs listed below the contribution margin. Instead, any presentation format can be used. The key point is that non-operating expenses are excluded from the calculation; instead, they are listed as a deduction from the operating profit margin to arrive at the net profit margin. The expenses not included in the calculation of the operating profit margin are income taxes, interest expense, interest income, and any gain or loss on asset sales.

A separate definition of the operating profit margin is that it is the same as the gross margin; which is revenues less the cost of goods sold.

Example of Operating Profit Margin

ABC Company has revenues of $10 million and an operating profit of $1.5 million. This is an operating profit margin of 15%, which is calculated as $1.5 million operating profit ÷ $10 million revenues.

How to Use the Operating Profit Margin

It is particularly useful to track the operating profit margin on a historical trend line to see if there are any long-term changes that management should be aware of. It can also be tracked in comparison to the average figure for the industry in which you operate, and against key competitors, to see if the company's core business is competitive. If the margin indicates that the core business is not competitive, then an analysis of the firm’s price points, distribution channels, and expense line items will likely be in order.

The operating profit margin is an especially useful metric for an acquirer, since this party is not concerned with the financial structure of a target company (which it will likely alter as a result of the acquisition). It is more interested in the core underlying ability of the company to generate earnings.

How to Improve Your Operating Profit Margin

Your operating profit margin is really based on the competitive stance of your business, which is derived from a tight focus on your core competencies and how you use them to maximize unit volumes and price points. If you are spending money in any areas outside of these core competencies, then these should be your targets for cost reductions - do not pare away expenses in critical areas. Also, consider whether it might make sense to outsource some activities to other parties that can perform them for less money. This is most likely in technical, high-volume areas such as payroll processing. It may also be possible to outsource staff in areas where you really only need a specialist on a part-time basis (such as an electrical contractor or a maintenance technician). The areas in which expense cuts can be enacted will vary dramatically by business.