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?"

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