Investors compare the operating profit margin of a company with the operating profit margin of industry competitors or a benchmark index such as the Standard & Poor's 500 index. For example, the average operating profit margin for the S&P 500 was 10.7% for the fourth quarter of 2018. A company that has an operating profit margin higher than 10.7% would have outperformed the overall market. However, it is essential to consider that average profit margins vary significantly between industries.
Operating profit margin is one of the key profitability ratios that investors and analysts use when evaluating a company. Operating margin is considered 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 its fixed and variable costs except for taxes and interest.
What the Operating Profit Margin Reveals
The operating profit margin informs both business owners and investors how efficiently a company can convert a dollar of revenue into a dollar of profit after accounting for all the expenses required to run the business. This profitability metric divides the company's operating income by its total revenue. There are two components to the operating profit margin calculation: revenue and operating profit.
Revenue is the top line on a company's income statement. Revenue, or 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 appears further down the income statement. It is a derivative of gross profit. Gross profit is revenue minus all the expenses associated with the production of items for sale, which is 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 determine the company's operating margin 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 potential financial vulnerability to an economic downturn or financial distress if a trend develops.
Operating profit margins vary significantly 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, chain retailers can function with lower margins due to their massive sales volumes. Conversely, small, independent businesses need higher margins to cover costs and still make a profit.
Example of Operating Profit Margin
Apple Inc. (AAPL)
Apple reported an operating income number of $61 billion (highlighted in blue) for the fiscal year ending 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 is not informative 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, a trend emerges over the past three years. Apple's operating margins have fallen by 3.4% since 2015. The analysis of a company's operating margin should focus on how the margin compares to its industry average and its closest competitors along with whether the company's margin shows an increasing or decreasing trend year by year.
The Bottom Line
A consistently healthy bottom line depends on rising operating profits over time. Companies use the operating profit margin to reveal trends in growth and to pinpoint unnecessary expenses. These unnecessary costs are eliminated by cost-cutting measures, which boosts the 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, the operating profit margin is also useful for the development of an effective business strategy as well as serving as a comparative metric for investors.