A:

Typically, an operating profit margin of a company should be compared to its industry or a benchmark index like the S&P 500. For example, the average operating profit margin for the S&P was roughly 11% for 2017. A company that has an operating profit margin higher than 11% would have outperformed the overall market. However, it's important to take into consideration that average profit margins vary significantly between industries.

Operating profit margin is one of the key profitability ratios that investors and analysts consider when evaluating a company. Operating margin is considered to be a good indicator of how efficiently a company manages expenses because it reveals the amount of revenue returned to a company once it has covered virtually all of both its fixed and variable expenses except for taxes and interest.

What Does Operating Profit Margin Tell Investors and Business Owners

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 income by its total revenue. There are two components that go into calculating operating profit margin: revenue and operating profit.

Revenue is the top line on a company's income statement. Revenue, which is sometimes referred to as net sales, reflects the total amount of income generated by the sale of goods or services. Revenue refers only to the positive cash flow directly attributable to primary operations. 

Operating profit sits 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). Since gross profit is a rather simplistic view of a company's profitability, operating profit takes it one step further 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, employee benefits, and insurance premiums. 

How Operating Profit Margin Is Calculated

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. The formula is as follows:

One of the best ways to evaluate a company's operational efficiency is to view the company's operating margin as it changes over time. Rising operating margins show a company that is managing its costs and increasing its profits. Margins above the industry average or the overall market indicate financial efficiency and stability. However, margins below the industry average might indicate financial vulnerability to an economic downturn or financial distress if a trend develops. 

Operating profit margins vary greatly across different industries and sectors. For example, average operating margins in the retail clothing industry run lower than the average operating profit margins in the telecommunications sector. Large, national-chain retailers can function with lower margins due to the massive volume of their sales. Conversely, small, independent businesses need higher margins in order to cover costs and still make a profit.

Example of Operating Profit Margin

Apple Inc. (AAPL)

Apple reported an operating income number of roughly $61 billion (highlighted in blue) for the fiscal year ended September 30, 2017, as shown in its consolidated 10K statement below. Apple's total sales or revenue was $229 billion for the same period.

As a result, Apple's operating profit margin for 2017 was 26.6% ($61/$229). However, the number by itself doesn't tell us much until we compare it to prior years. 

  • 2017 Operating margin = 26.6% ($61/$229).
  • 2016 Operating margin = 27.9% ($60/$215).
  • 2015 Operating margin = 30.0% ($71/$234).

By analyzing multiple years, we can see that a trend has developed over the past three years where Apple's operating margins have fallen by 3.4% since 2015. Analysis of a company's operating margin should focus on how it compares to its industry average and its closest competitors, along with whether the trend of the company's margin is generally increasing or decreasing year by year.

The Bottom Line

A consistently healthy bottom line depends on rising operating profits over time. Companies use operating profit margin not only to spot trends in growth, but also to pinpoint unnecessary expenses to determine where cost-cutting measures can boost their bottom line. To gauge a company's performance relative to its peers, investors can compare its finances to other companies within the same industry. However, this metric is also useful in the development of an effective business strategy as well as serving as a comparative metric for investors.

For more financial analysis, please read "How the Income Statement and Balance Sheet Differ?"

RELATED FAQS
  1. Profit margin versus operating margin: What's the difference?

    There are some distinctions between profit margin and operating margin. Both measure efficiency of a firm, but one takes ... Read Answer >>
  2. How do gross margin and profit margin differ?

    Gross margin and profit margin are profitability ratios used in evaluating a company's financial health, but they have distinct ... Read Answer >>
  3. How does gross margin and net margin differ?

    Gross margin or gross profit margin and net profit margin are both profitability ratios used in determining the financial ... Read Answer >>
  4. What is a good operating margin for a business?

    Read about what it means to have a good operating margin and why that answer depends heavily on competitive and historical ... Read Answer >>
  5. What is the average profit margin for a company in the oil & gas drilling sector?

    Understanding the profit margin is an integral aspect of analyzing whether an oil & gas drilling company is a worthwhile ... Read Answer >>
Related Articles
  1. Investing

    A Look At Corporate Profit Margins

    Take a deeper look at a company's profitability with the help of profit margin ratios.
  2. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  3. Small Business

    How Gross Margin Can Make or Break Your Startup

    Find out how your startup's gross margin can impact your business, including why a mediocre margin may spell disaster for a budding business.
  4. Investing

    What Is the Best Measure of a Company's Financial Health?

    Discover the single best financial metric that investors can use for determining the financial health and long-term sustainability of a company.
  5. Investing

    Is Net Income The Same As Profit?

    Net income and profit both deal with positive cash flow, but there are important differences between the two concepts.
  6. Investing

    Finding Your Margin Investment Sweet Spot

    Borrowing to increase profits isn't for the faint of heart, but margin trading can mean big returns.
  7. Investing

    Operating Profit

    Operating profit is the profit generated from the core business of a company before accounting for interest and taxes.
  8. Investing

    How Operating Leverage Can Impact a Business

    Operating leverage can tell you a lot about a company and its future profitability, and the level of risk it offers to investors. Learn the pros and cons.
RELATED TERMS
  1. Profit Margin

    Profit margin is a profitability ratios calculated as net income ...
  2. Operating Margin

    Operating margin is a measure of a company's profitability, and ...
  3. Net Profit Margin

    Net profit margin, or net margin, is equal to net income or profits ...
  4. Profit

    Profit is the financial benefit realized when the amount of revenue ...
  5. Margin

    Margin is borrowed money that is used to purchase securities. ...
  6. Gross Margin

    A company's total sales revenue minus its cost of goods sold, ...
Trading Center