A:

The operating profit margin informs both business owners and investors about a company's ability to turn a dollar of revenue into a dollar of profit after accounting for all the expenses required to run the business. This profitability metric is calculated by dividing the company's operating profit by its total revenue. To understand this concept thoroughly and why it is such an important measure of a business's viability, it is first necessary to understand the underlying elements: revenue and operating profit.

Revenue is most easily thought of as the top line on a company's income statement. This figure reflects the total amount of income generated by the sale of goods or services. While many larger companies may have alternate income streams, such as interest earned on investments, revenue refers only to the positive cash flow directly attributable to primary operations. The revenue of a company that sells furniture is the income generated by those sales. If the company also leases equipment or land to another business as a means to augment its income, this income is excluded from the revenue figure and accounted for elsewhere on the income statement.

Operating profit sits a little further down the income statement and is derived from its predecessor, gross profit. Gross profit is revenue minus all the expenses associated with the production of items for sale, called cost of goods sold (COGS). This includes a number of fixed and variable expenses, such as the cost of raw materials, wages for labor required for manufacturing or assembly, and depreciation expenses for equipment wear and tear. Gross profit and its corresponding profitability ratio, the gross profit margin, reflect the company's ability to generate profit after accounting only for the production of goods for sale.

Since gross profit is a rather simplistic view of a company's profitability, operating profit takes things one step further. Operating profit is calculated by subtracting all overhead, administrative and operational expenses from gross profit. Any expense necessary to keep a business running is included, such as rent, utilities, payroll and its attendant taxes, employee benefits, and insurance premiums. Also included are other types of depreciation not directly associated with production and amortization. Neither gross profit nor operating profit include costs associated with payment on debts, taxes or additional income streams.

By dividing operating profit by total revenue, the operating profit margin becomes a more refined metric. Operating profit is reported in dollars, whereas its corresponding profit margin is reported as a percentage of each revenue dollar. A company with revenue totaling $100,000 and a 65% profit margin retains $65,000 in profits after accounting for all production and operational expenses.

Since a healthy bottom line depends on a robust operating profit, companies use this calculation to pinpoint unnecessary expenses and to determine where cuts can be made in order to bolster profitability at every level. However, the format of this metric means it is useful in the development of effective business strategy as well as serving as a comparative metric for investors. To gauge a company's performance relative to its peers, investors compare its finances to other companies within the same industry. A business with an operating profit margin of 65% in an industry where the average margin is only 50% is a likely candidate for investment.

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