Hey there I'm James and in this video I'll explain how operating profit margin works with an example
operating profit margin or operating margin is operating profit divided by revenue
it's another profitability ratio similar to gross profit margin which we covered in my last video
this one measures a business's ability to generate operating profit from each unit of revenue earned
if we multiply it by 100 then we can express it as a percentage
so how does operating profit margin work? we'll begin with profit
profit is the financial gain generated in a business when its revenues are bigger than its expenses
in a basic income statement like this one we can find it sitting at the bottom
okay but what about operating profit?
this basic income statement only has one line for expenses if we want to look at it in more detail
then we can expand it out first we take away the direct cost of sales or cost of goods sold
these are the variable expenses that are directly involved in producing products
that gets us to gross profit the big profit and below that we subtract all of the businesses operating expenses
these are the ongoing day-to-day costs involved in running a business things like research and development
selling, general, admin expenses, depreciation and amortization
this is where operating profit comes in it's the financial gain left in the business after deducting all
the direct cost of sales and operating expenses below that we also remove interest and tax
which is why operating profit is sometimes called earnings before interest and tax or 'EBIT' for short
but we'll go with operating profit on the bottom line we're left with net profit
which we'll get on to next time so click subscribe if you'd like to watch that
you can find all of these videos in my financial ratios playlist which I'll link to in the description
so one more time what is operating profit margin? operating profit margin is a business's operating profit
divided by its revenue and by the way you can find this formula on my
profitability ratios cheat sheet which you can find in the description as well
it measures how much operating profit they're able to generate for each dollar of revenue earned
it only accounts for the businesses direct cost of sales and operating expenses
it ignores the interest and tax expenses which we can see further down the income statement
great so let's do an example here's the income statement for a business called 'MAD'
a tech company that makes semiconductor products it summarizes the revenue they earned
and the expenses they incurred over a one year period but what is MAD's operating profit margin?
well we can see that they earned revenue of 1 billion dollars and after subtracting their cost of sales
and operating expenses they were left with an operating profit of 150 million dollars
so their operating profit margin is 150 million dollars in operating profit divided by 1 billion dollars in revenue
that's 15 cents of operating profit generated for each dollar earned or 15% when we times it by 100
very nice but whilst it's helpful for us to know this number
operating profit margin becomes more valuable when we make comparisons for example we can compare it year on year
here are MAD's income statements for the past two years in the current year they generated 150 million dollars
in operating profit with an operating margin of 15%
but in the previous year they only managed an operating profit of 70 million dollars
when we divide that by their revenue of 700 million dollars we can see that their
operating profit margin was 10% so overall that's a 5% increase in operating profit margin year on year
which is not bad at all we can also compare operating profit margin against similar businesses
this time we've got the current year income statements for MAD and INLET two competitors
in the same industry INLET is the market leader in semiconductor products and they earned a whopping
7.8 billion dollars in revenue and their operating profit was 2.34 billion dollars
2.34 divided by 7.8 is 0.3 or 30 percent so not only is INLET earning more revenue than MAD
they're also converting each dollar of that revenue into operating profit more efficiently
what causes a decrease in operating profit margin? warning i'm going to do a little bit of
math here to help explain this operating profit margin is operating profit divided by revenue
we saw earlier that operating profit is the same as gross profit minus operating expenses
now if we separate this into two fractions and divide gross profit by revenue then operating profit margin
is equal to gross profit margin minus operating expenses divided by revenue how does this help us?
well it shows us that there are two ways that operating profit margin can decrease either the gross profit margin
has gone down for all of the reasons that i mentioned last time in the gross profit margin video
or operating expenses have increased as a proportion of revenue perhaps they're spending
more on research and development or administrative expenses or maybe the business has been selling
their products or services at a discount on the other hand what causes an increase in operating profit margin?
we've still got the same formula but the arrows have flipped around gross profit margin
could have gone up which would have a knock-on effect on operating profit margin or the
businesses operating expenses have decreased relative to the revenue it earned it could have
hiked the prices on its products or services or it could have reduced its operating expenses through
better cost management as always a big thanks to all my channel members
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