Every day businesses deal with numbers and ratios to measure performance in terms of finances, operations and efficiencies. One such measure to measure all these metrics operating profit ratio. It helps to measure the performance of your company for every rupee worth of goods your company has earned. In simpler terms, operating profit margin means how much profit your business makes after the sales of its goods and services.
The operating profit ratio is computed by dividing the operating income by the net sales of the company. If the operating margin ratio is high, it means that your business is doing well. In contrast, if your operating profit ratio is lower it means that your business has inefficiencies.
Understanding Operating Profit Ratio
You might be wondering how an operating profit ratio is obtained. You can easily get the ratio by dividing the operating income by the net sales. This ratio is crucial as it determines how much profit a business is making for each rupee worth of sales. An important point to note here is that the operating profit ratio does not include taxes or interests.
Operating profit margin is the ratio of the revenue it makes after selling its goods or services. You can assume that the amount earned from your business as a salary and the profit a business makes is the return on investment(ROI). The viability of the processes can be determined by the division of these two numbers.
The operating profit ratio is vital as it gives detailed information regarding the company’s efficiency in managing its core operations and delivery costs. Operating profit also helps the business in numerous ways such as keeping the prices competitive, like should be feasible to periodic discounts and offers. In addition, it helps you to comprehend the ways to keep your operations streamlined which will assist in achieving better margins for your product.
In the operating profit ratio, the profitability of the company is reflected, like how much profit a company is capable of making. If the ratio of the operating profit is higher, it means that your company is performing better. Plus, if there is a high variance in the operating profit ratio, it indicates that your business is risky. However, there will be fluctuations in earnings and sales if the ratio is in variance frequently.
The operating profit ratio cannot be applied if you want to compare companies of distinct industries. If you are planning to invest in any business, consider going for companies whose operating profit ratio is stable. This approach will give deeper insights regarding the operational efficiency of the company including its sales and earnings.
Also Read : What are Operating Costs?
Calculating the Operating Profit Ratio
The operating profit ratio can be calculated in numerous ways, however, let us look at the standard formula commonly used:
Operating Profit Ratio = (Operating Income / Revenue) x 100
⇒Some of the components of the operating profit ratio are given below:
An operating income has many variables. Operating income can be gained after deducting operating expenses from gross revenue. Gross revenue is the total earnings from all sources before subtracting taxes. Wages, cost of goods sold(COGS), rents etc. are included in the operating income.
Net sales are similar to gross sales which means they cover the overall sales of the business minus the allowances, discounts and returns. It does not include the cost of goods sold(COGS).
How to calculate the Operating Profit Ratio?
The operating profit ratio can be calculated by dividing operating income by net sales. This formula can be interpreted as a percentage, representing the profit earned per unit of currency in sales. Operating margin means that you can get insights into the operational expenses of a company like if the company is on the correct margin.
Operating profit ratio can be obtained in several ways:
Operating Profits = Revenue – (Direct Costs + Indirect Costs)
Operating Profits = (Net Profit, before paying tax + Non-Operating Expenses) – Non-Operating Earning
Operating Profits = (Gross Profit + Operating Income from Other Sources) – Other Operating Expenses
⇒The net sales is computed using this formula:
Net sales = (Sales in Cash + Sales in Credit) – Sales Returns
Significance of Operating Profit Margin
Operating profit margin is essential to evaluate the operational efficiency of the company. Businesses invest time, money and manpower to gain profit from their core operations. If a company isn’t making money for every dollar it invests or if the profit margin decreases with each dollar in sales, it indicates issues with operational and production cost efficiency.
The operating profit margin has to be maintained at least closer to 20%. The analysis of the operating profit margin will help the company to bring the operating expenses lower. The company can focus on areas to reduce costs.
Limitations of Operating Profit Margin
The operating profit margin is a number calculated from fixed values, showing only a snapshot of how well a company is doing at a specific moment. The operating profit ratio approach will not provide a bigger picture of the company’s operations.
The operating margin is used by the investors to compare companies of the same industry. Companies of different industries cannot be compared. Another significant drawback of the operating profit ratio is that it doesn’t account for certain financial obligations. The interest on debt and taxes that a company must pay are not considered in this ratio. This means that even if the operating profit ratio appears favourable, the company might be using most of its profits to pay off existing debts.
Example of Operating Profit Ratio
Let us look at an example of an operating profit margin. Suppose a company has an operating profit margin of Rs 500,000 and sales of Rs 1,000,000. The operating profit ratio is calculated by dividing operating profit by sales and multiplying by 100. In this case, (Rs 500,000 / Rs 1,000,000) * 100 equals an operating profit ratio of 50%.
Conclusion
The operating profit ratio is beneficial for the business to calculate the performance of the business in terms of operational efficiency. ERP software is an advanced business management solution which will help the business to use this approach efficiently. Implement this solution for a smooth performance analysis.
