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Operating Profit Margin

Operating profit divided by total revenue, expressed as a percentage

What is Operating Profit Margin?

Operating Profit Margin is a profitability, or performance, ratio used to calculate the percentage of profit a company produces from its operations, prior to subtracting taxes and interest charges. It is calculated by dividing the operating profit by total revenue, and expressed as a percentage. The margin is also known as EBIT (Earnings Before Interest and Tax) Margin.

Operating Profit Margin often differs across companies and 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.

 

Operating Profit Margin

 

How to Calculate Operating Profit Margin?

 

Operating Profit Formula

 

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 a 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.

 

Operating Profit

 

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 the 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 new debt, which would then make historical interest expense irrelevant.

A company’s operating margin is indicative of how well it is managed because operating expenses such as salaries, rent, and equipment leases are variable, rather 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, but 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 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.

 

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Operating Profit Margin

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Limitations of Using the Operating Margin Ratio

As in any part of financial analysis, any number of interest requires additional research to understand the reasons behind the potential difference(s). 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 declining balance may report lower operating 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.

Other Resources

  • Profitability Ratios
  • Depreciation Expense
  • Straight-Line Depreciation
  • Financial Analyst Certification Program

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