As a small business owner, monitoring your company’s sales is part of understanding the financial health of your company. Just as important is tracking the costs needed to generate those sales, including salaries, rent, and supplies.
The difference between sales and the associated costs shows your business’s profitability. This gap between the two is called the operating profit margin, and the bigger the spread between sales and costs, the better.
Here’s what you need to know about operating profit margin as it pertains to your business’s financial performance.
What is operating profit margin?
Operating profit margin, also called operating margin, is the ratio of a company’s operating profit to its sales or revenue. Operating margin is just one of several ways to measure profit margin. It is usually expressed as a percentage; the higher the percentage, the more profitable the company is.
Operating profit, a key component in deriving operating margin, is determined by subtracting operating expenses from net sales. Net sales is total sales minus any customer returns.
Two buckets of costs comprise operating expenses:
- COGS, or cost of goods sold, are direct costs associated with production, such as wages for labor and raw materials.
- SG&A, or selling, general, and administrative costs, are indirect costs of the business, such as office rent, utilities, staff payroll, and advertising and marketing expenses. SG&A is sometimes called overhead or fixed costs.
Costs for interest on debt and taxes don’t figure in the calculation because they aren’t operating costs.
Business managers, financial analysts, and investors use operating margin to examine a company’s profitability and to compare its profitability to similar companies in the same type of business. Service providers, tech companies, and luxury goods makers tend to have wider operating profit margins, while industries such as auto manufacturing and supermarkets have narrower margins. Operating margins for ecommerce vary widely, with big online marketplaces such as eBay and Etsy reporting some of the widest. Online retailers, like most other types of retailers, have much narrower operating margins.
How to calculate operating profit margin
Calculating operating margin starts with the formula for operating profit. This is expressed as:
Net sales - COGS - SG&A = operating profit
The operating profit margin formula then is:
Operating profit / net sales
For example, let’s say an online patio furniture retailer has net sales of $20 million and operating expenses of $16 million. The operating profit calculation might look like this:
|Production costs (COGS)
|Overhead costs (SG&A)
The company’s operating profit margin then is:
$4 million / $20 million = 0.2, or 20%
Said another way, the operating margin means the furniture company generated 20¢ of operating profit for each $1 of sales.
Operating margin vs. gross margin vs. net margin
Operating margin is one of three key profitability ratios business managers, analysts, and investors use to gauge a company’s performance. The other two are:
Operating margin vs. gross margin
Gross margin is another ratio (which is often expressed as a percentage), though it almost always is higher than the operating margin, because it accounts only for the cost of goods sold while leaving out SG&A, or overhead costs. Gross margin is calculated by dividing gross profit by sales. As an example, the online patio furniture maker’s gross profit is:
$20 million sales - $12 million (COGS) = $8 million
Its gross margin therefore is:
$8 million gross profit / $20 million sales = 0.4, or 40%
In this case, the gross margin of 40% is double the operating profit margin of 20%.
Operating margin vs. net margin
Net margin is almost always a lower percentage figure than operating margin because it accounts for all costs, including interest and taxes. It is calculated by dividing net income by sales. Let’s say the furniture company had a total of $1 million of expenses from interest on debt and taxes. Net income (also known as net profit) is operating profit minus these two non-operating expenses:
$4 million - $1 million = $3 million
The net margin then is:
$3 million / $20 million = 0.15, or 15%
In this example, the net interest margin of 15% is lower than the operating profit margin of 20%.
What affects operating profit margin?
Various factors can affect a company’s operating profit margin. They are classified as either internal factors—those the company can control—or external factors, which it can’t.
Internal factors that affect operating profit margin
- Production volume. Higher or lower output can reduce or increase the profit margin, as a business’s fixed costs are spread over higher or lower sales generated from the increase or decrease in output.
- Price. A price increase for a service or product, or a price cut, can change the operating margin.
- Cost of goods sold. A change in direct production costs can affect the business’s operating margin. For instance, a wage increase for factory workers might lower the margin, while switching to a lower-cost supplier could boost it.
- Selling, general, and administrative expenses. These costs, also known as overhead, don’t change much when output rises or falls. Companies often cut these expenses when they target a long-term increase in operating margin. For example, if a company wants to reduce rent, it might have to move to smaller, less expensive office space.
- Depreciation and amortization expenses. These are noncash expenses based on the estimated loss of productive value for company assets. This is an accounting device that spreads the purchase cost of an asset over a period of time, instead of all at once. For example, if a company buys workstations and laptops for the office and sales staff and depreciates their value over five years, that expense reduces operating profit for that period of time.
External factors that affect operating profit margin
- Economic conditions. An expanding economy benefits most companies, and vice versa when the economy contracts. A growing economy means consumers have more income to spend, giving businesses an opportunity to sell more, increase production, and spread their fixed costs over more output.
- Demand. A sought-after product usually bodes well for a company’s sales, profit, and the operating profit margin, because the company can sell more, command higher prices, or both. Weaker demand and falling sales squeeze the margin.
- Competition. Little or no competition may free a company to increase prices or production, boosting the operating margin. A competitive market and ample product supply hampers a company’s ability to raise prices or production.
How to improve operating profit margin
Two simple levers drive operating profit and margins—sales and expenses. A business can increase sales by raising prices or increasing output. Alternatively, it can reduce the cost of goods sold (COGS) or selling, general, and administrative expenses (SG&A).
A business has more direct control over SG&A expenses, which are discretionary to some degree. The business could rent a smaller office, lay off workers, or cut advertising costs, for instance. Reducing COGS could be more difficult because workers may refuse to accept wage and benefits cuts, and suppliers might reject requests for price reductions.
Businesses seeking to widen their operating profit margin often consider expanding to achieve greater economies of scale, gaining more output at lower per-unit costs. A business can expand internally by producing more, adding new products, or moving into new markets. Or it might expand externally, acquiring another business.
What operating profit margin doesn’t tell you
The operating margin provides important information to business owners and investors, particularly by examining the margin over time and comparing it with competitors. But it doesn’t tell them everything. Other things to consider include:
- Nonoperating results. For example, company income from investments increases net income, but not operating profit. This could signal the company is relying on other things to boost profitability.
- Restructuring costs. One-time operating expenses to restructure in an effort to restore or increase profitability will hurt the margin in the short term.
- Interest and taxes. Interest on debt and taxes are not factored into operating profit, so a company must understand how much of its operating profit is available to pay these expenses. A business with high operating margins is better able to handle the interest and tax burden.
- Cash flow. This usually differs from profit, which typically includes an array of expenses that are excluded from cash flow. Cash flow is traditionally the strongest predictor of a company’s value, especially when analyzed using a technique known as discounted cash flow, which shows how much a dollar in the future is worth today.
- Growth rate. A mature company may have high operating margins but a lower growth rate, while a newer, fast-growing company with high expenses might report operating losses in the early years.
Operating profit margin FAQ
What is a good operating profit margin?
Operating margins are relative, depending on the industry and whether a company has high non-operating expenses, such as taxes and interest on debt, or restructuring costs. A good operating margin, for instance, might be 25% if other companies in the industry generate 15% margins. A steadily widening operating margin, meanwhile, signals that a company is succeeding in key aspects of its operations.
Is a high operating margin good or bad?
A high operating margin is obviously better than a low one. Companies that borrow to purchase assets, for example, want wider margins so they can pay the interest on the debt and taxes while still having a significant amount left over to count as net income. More important than a particular percentage, however, is to look back at the operating margin over time. Varying or erratic operating margins can be a sign of problems the company has in maintaining output and prices, or in controlling costs.
What are the consequences of having a low operating profit margin?
A business with a low operating margin may have some difficult decisions to make. It could begin an effort to boost sales, but that could mean more costs for sales staff or discounting prices to lure customers. It could try to negotiate lower prices from suppliers or change suppliers. Low-margin businesses also may have difficulty obtaining loans or attracting investors.