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Operating profit margin is a measure for how much income a company earns from its sale. The ratio often falls under the standard profitability ratios used by companies. Owners and managers can calculate this profitability measure for each accounting period. The basic operating profit margin formula is operating income divided by total sales revenue. Operating income is gross profit, less operating expenses and depreciation. This is essentially net income from the income statement, as determined by standard accounting principles.
Gross income is sales revenue less discounts, returns, allowances and cost of goods sold. This figure helps a company determine how much of the money it earns goes to pay for the items it sells. Service companies tend to have fewer cost of goods sold while retail and manufacturing firms will have more. This information also comes from a company’s income statement. It is the starting block for the operating profit margin formula.
Using the formula above, a company can now calculate its operating profit margin. A company has $75,000 US Dollars (USD) in gross profit, $40,000 USD in cost of goods sold and $20,000 USD in operating expenses. The company’s operating income is $15,000 USD. The company’s operating profit margin is 20 percent. This means the company earns $0.20 USD profit for every $1 USD in sales.
Profit margin and its relating formulas help a company benchmark its income against other firms in the industry. This allows business owners and managers to determine where they need to lower costs in order to increase profit. For example, looking at the individual components in the operating profit margin formula can help companies focus on a specific area of business operations. On the other side, companies can also see if their sales are lower than other firms in the industry. This comparison process helps companies become more competitive through the use of profitability ratios.
The operating margin should not be the only profitability ratio a company uses. Financial accounting information can contain flaws that distort ratios. For example, using an aggressive strategy to record sales can lead to a skewed ratio. This income reported on the income statement may not be realized by the firm. The cash received from profit will also be lower and of little use to the company.
Another consideration is to remove non-recurring items from the income statement. These items are infrequent and can increase or decrease a company’s net income. These extraordinary items may also need disclosures so owners and managers know which items are non-recurring on the income statement.