Operating Profit Margin Ratio


Definition

Operating Profit Margin Ratio is the percentage of operating profit (i.e. profit before interest and tax) relative to the revenue earned during a period.

Operating Profit Margin Ratio is also known as Operating Income Percentage and Operating Margin Ratio.

Formula

Operating Profit Margin Ratio=Operating Profitx100%
Revenue

Where:

  • Operating Profit = Net Profit + Interest Expense + Tax Expense - Other Income

= Gross Profit - Selling, General & Administrative Expenses

  • Revenue is income earned from the principal business activities

Example

ABC PLC is in the business of manufacturing stationery supplies.

The financial results of ABC PLC for the year ended 30 June 20X4 are as follows:

$ Million
Income
Sales revenue from selling stationery150
Gain on disposal of investments30
180
Expenses
Production Cost60
General and administrative expenses40
Taxation15
Interest expense on bank loan10
125
Net Profit (Income Less Expenses)55

Operating Profit Margin Ratio will be calculated as follows:

Operating Profit %=Operating Profitx100%
Revenue
Operating Profit %=Net Profit + Interest expense + Tax expense - Other Incomex100%
Revenue
=$55 + $10 + $15 - $30x100%
$150
=33.3%

Notes:

  • Gain on disposal of investments is not considered as revenue as it is not earned from the principal business activity of ABC PLC, i.e. selling stationery goods.

Explanation

Operating Profit Margin Ratio is a measure of an organization's profit generation efficiency. OP Margin of 20% means that every $1 of sale earns a profit of 20 cents for the business before taking into account taxation, interest expense and other income.

The exclusion of other income, taxation and interest expense from the calculation of profit margin arguably provides a better measure for assessing the underlying financial performance of a business as compared to net profit margin ratio because it places emphasis on only the recurring profits of a business which are not affected by fluctuations caused by changes in gearing level, tax rates and one-off gains.

The difference between gross margin ratio and operating margin ratio is the inclusion of non-production overheads (i.e. selling, distribution, general and administration expenses) in the calculation of operating margin.

Analysis & Interpretation

The trend of Operating Margin Ratio should be analyzed over several periods in the context of the industry sector in which the company operates.

Generally, a higher operating profit margin is desirable as it suggests greater potential to derive profits and more cushion against any increase in competition or costs.

A change in OP Margin Ratio could be attributed to several factors as discussed below:

a) Increase in OP Margin Ratio & Decrease in GP Margin Ratio

Possible Causes:

  • Reduction in the proportion of non-production overheads due to economies of scale as a result of which fixed overheads (e.g. salaries of management, office rent, etc.) are distributed over a greater number of sales units.
  • Cost curtailment measures (e.g. eliminating overstaffing, promoting lean management) to reduce the impact of falling gross profit margin.

b) Increase in OP Margin Ratio & Increase in GP Margin Ratio

Possible Causes:

  • Increase in sales volume causing a decrease in the proportion of both production and non-production costs due to economies of scale.

c) Decrease in OP Margin Ratio & Increase in GP Margin Ratio

Possible Causes:

  • Increase in the proportion of selling, general and administrative expenses (e.g. advertisement, management salaries, rent) due to recent expansion of business into new markets whose revenue potential has not yet been realized.

d) Decrease in OP Margin Ratio & Decrease in GP Margin Ratio

Possible Causes:

  • Operating inefficiencies (e.g. overstaffing, lower productivity, poor cost control).
  • Increase in competition (e.g. saturation in existing markets forcing companies to seek business in less profitable markets).