In this episode, we explore the Operating Profit Margin and its significance for your business. The Operating Profit Margin is a crucial metric that shows how much profit your business generates from its core operations after covering costs such as operating expenses and the cost of goods sold. Knowing how to calculate and interpret this margin is essential for any business owner.

How to Calculate Operating Profit Margin

Firstly, calculating the Operating Profit Margin involves dividing the operating profit by the total revenue and then multiplying by 100 to get a percentage. For instance, if your business has £100,000 in revenue, £50,000 in the cost of sales, and £30,000 in operating expenses, the operating profit is £20,000. Consequently, dividing £20,000 by £100,000 results in a margin of 20%. This percentage provides a clear indication of how effectively your business is managing its costs relative to its revenue.

What Affects Your Operating Profit Margin

Several factors can have an impact. Industry standards, the size of your business, and management decisions all play a crucial role. For example, margins in the aviation industry are often lower compared to those in the hospitality sector. Hence, it is important to compare your margin with similar businesses or against your own historical performance. Moreover, investments in infrastructure or changes in operations can also affect your margin over time. By regularly reviewing these factors, you can gain valuable insights into your business’s performance.

Why It’s Important to Know Your Margin

Understanding your Operating Profit Margin is vital because it helps you gauge how efficiently your business is running. A high margin indicates that your business is controlling its costs effectively and generating a substantial amount of profit from its operations. Conversely, a low margin may suggest issues such as high operating costs or insufficient sales. Therefore, monitoring your margin can help you identify areas needing improvement and make informed decisions to enhance profitability.

Final Thoughts

To sum up, tracking and understanding your Operating Profit Margin is key to ensuring your business’s success. It provides important insights into how well your business is performing and where improvements can be made. For more tips and guidance on managing your business finances, be sure to listen to the I Hate Numbers podcast.

When running your business, you need to keep an eye on your profits. Whether your business is a private business, a social enterprise, or not-for-profit, keeping an eye on profits is important. And profit isn't a one-size-fits-all term. There are several different profits that you need to be aware of. In this week's podcast, I'm going to be focusing on operating profit, specifically, something called the operating profit margin.

I'm going to be looking at how we make the calculation, what it actually means, what influences the amount of operating profit margin we generate, how do we know if our margins are good or bad or indifferent, and some of the factors that will influence the size of the margin that we generate. Let's crack on.

Now, firstly, I want to outline two types of numbers that you're likely to meet in the financial world - and by types, in terms of how they're presented, how they're expressed. One number is expressed as what's called a relative number, typically a percentage, a fraction, a decimal, and in this context, I'm going to be referring to a margin as a percentage. The other type of number that how it's presented by the way is called an absolute value, and that's actually measured in the financial amount of pounds, dollars, or whatever currency you're trading in. Now, your operating margin, brackets operating margin percentage, is a measure of your business's profitability.

It tells you fundamentally how much profit your business is generating from its core operations. And this is after you take off what is referred to as cost of goods sold, quite a mouthful there, and your operating expenses. You may, folks, by the way, come across different terms for those two items I've referred to.

Cost of goods sometimes is called cost of sales. Some people use the expression direct costs. And operating expenses can be referred to as overheads, running expenses, and I can't really tell you why so many different terms exist, but if there's one term that exists in the finance world, us finance people will find a way to add a different variation.

Now, your operating profit margin is not the same as your gross profit margin because it won't be including things such as interest on your loans and borrowings, interest that you might receive from the investancy undertaking, or the taxes that you're liable for. The gross profit margin also, by the way folks doesn't include running costs or operating expenses, is purely comparing your cost of sales figure against your revenue. Now the operating profit is your gross profit deducted from that all the expenses, all the running expenses that you have in your business. And just add to this, by the way, if you hear the word operating profit, alternative terms that I've come across in my 30+ years of experience are net profits, some people use the term EBIT as a shorthand and acronym, which stands for earnings before interest and tax, UK equivalent is PBIT, which stands for profits before interest and tax.

Whichever way you carve it up, operating profit is before the consideration of interest and also tax charges. Now why do we need to know what the operating margin is? Well, because it's a good indicator, gives you good insight to how efficient your business is being run. It also indicates how well your management team, who are considered largely to be responsible for those operating costs and cost of sales, how efficiently they're operating as well.

A high margin means that you're generating an amount of profit in excess of what you might be expecting. A high margin means you're generating a lot of profit from your operations and your business is running smoothly. A low margin could mean you're not selling enough or your operation expenses are too high.

Now, a word of caution here, folks, when we do look at our figures, a figure by itself in isolation is absolutely useless. You need to have a benchmark. You need to have a context. You need to have a yardstick to which to compare it. Operating margins, for example, in the aviation industry, would not be the same as operating margins for a restaurant or the hospitality sector, or perhaps a service-based business like a firm of accountants. Cough, cough.

Also, if you're looking at your operating margin, make sure you've got a context and you're comparing it to either where you expect it to be, your plan, your budget, what you generated in previous periods, but make sure that number is compared to something that's meaningful. The next thing I want to look at is how do we actually calculate the operating profit margin.

Well, step one is we calculate the actual operating profit in pounds, or again substitute for your own currency. Now to do this, we need to know what our business's revenue is, we need to know what the equivalent cost of sales are and we also need to know the operating expenses. These numbers should be extractable quite easily from your accounting system, and if you're not able to extract those numbers quite easily, then I would suggest you need to visit and see what your infrastructure is like and go digital and make sure your accounting system is fit for purpose.

Please check out the link in the show notes, by the way, if you want to have further information on this or find out more. Now, operating expenses will include things like utility bills, insurance costs, staff salaries and wages, rent, and rates. Now, once you have this information to hand, you can calculate your operating profits by deducting from your total revenue, your cost of sales and operating expenses.

Remember, do not deduct the interest costs or the tax charges. They are not included in operating profit. Let's throw a few numbers into the mix. Assume your business has got a total revenue of 100,000 pounds last year. Your cost of sales or cost of goods sold was 50,000, and the operating expenses were 30,000.

That gives you a total operating profit of 20,000, and by way of a footnote, your gross profit would be 50,000. Now the next stage is to calculate the margin, and the margin is one number that's expressed as a relative figure i.e. in this case, as a percentage. Take your operating profit, divide it by your total revenue, and depending on what sort of calculator you have, multiply by 100.

If you're doing it on a spreadsheet, then the spreadsheet can be formatted accordingly. So using these numbers, we have a 20,000 pounds operating profit, we have a 100,000 pounds revenue, so 20 divided by 100 times 100, it gives you that 20% figure. Okay, so we got some understanding how we calculate the number.

We've got some understanding what it's made up of. But how do we know if it's good, it's bad, or it's indifferent? Well, critically, what we need to do is to compare that figure to something, something that's meaningful to us, something that's appropriate, something that's relevant for our business. So comparing, for example, a hospitality business to an aviation or transportation company is meaningless.

Comparing you as perhaps a small restaurant to a large restaurant chain, again, there is some comparability there, but it's not necessarily a like for like comparison because of sizes and everything else. If you compare it internally, look at your previous performance, look against your budget or your plan, and if you don't have one in place, then you need to really seriously think about having such a thing.

And check out the show notes at the end, by the way, for a link to our online planning platform, Budgetwhizz. Now, by nature, operating margins will be lower than the gross profit margin, because, remember, we haven't included overheads when we've calculated the gross profit margin. Now, if we see a movement upwards on the operating margin, let's say, for argument's sake, last year in our example, we had 15 percent profit margin.

This year we've got 20%, that's an improvement upwards. Now, there are a number of variables that can affect that. It could be we're selling more, and because our costs are relatively static, as far as our operating costs are concerned, then we'd expect to see a bigger percentage. It could be we're being more cost-efficient, being more productive,

and that will filter through. It could be our gross profits are improving, and therefore that will feed through into the operating profit margin. If however there's a decline and there's a movement downwards, again there could be a number of factors influencing that decline. It could be a conscious choice, we've just undertaken some investments, built up our infrastructure, investing more money in the business and therefore the operating costs, for example, things like additional depreciation, staffing salaries and the like are going to go up.

And we're not quite there yet, and the business isn't matured. We haven't realised all the revenues that we expected. Therefore, we'd expect to see a decline. Also, it could be we're being less efficient. We could be seeing a decline in our business. But what it should tell us, it gives us an indicator to investigate even further.

The reasons for the movement will be fundamentally due to something going on with the cost of sales, something going on with the revenue, or something going on with the operating expenses, or a combination of all three of those factors. In next week's podcast, by the way, folks, I'm going to be looking at something called economies of scale, and that will link back to our conversation today.

I said earlier, how do we know if what we've got is good or bad? Well, one insight will be gained by comparing that figure to how we performed previously, how we expected to perform, what our plans were, and benchmarking against that. Be very careful in terms of comparing yourself to other companies in your sector, make sure you're comparing like with like.

Make sure you're careful when you compare yourself to a different industry. Different industries will operate with different operating profit margins. So, for example, in the transportation sector, aviation, shipping, and the like, you'll find the operating margins will be relatively small. So in aviation, operating margins are going to be quite small in terms of single-digit figures, perhaps, but they've got huge volumes of turnover, and therefore a small percentage applied to a big value would give them a large amount of pound note profit.

Conversely, you may find in certain sectors, like service-based organisations, consulting, training companies, because the overhead base is quite modest, they will be generating higher profit margins. So what feels right for you may not be necessarily correct for somebody else. So what are the final thoughts, the conclusions?

Well, first of all, for me, it's important that you've got a good infrastructure and a data capture system to be able to extract the information to do these calculations. Please do check out the Budgetwhizz platform, by the way, and that online planning and calculation of metrics is part of that, and you can use that to compare with what you're actually capturing within your Xero account.

Operating profit margins will give us good insights to how we're performing. Profit is still an easily extractable figure, and it's a concept that most people will have an appreciation of, if not fully understand. And those metrics, matched up with other metrics that we have, give us a good insight and indicator how we're performing.

It will point us through to where the stress points are, where the successes are in our business. Folks, I hope you found this useful. I'd love it if you could share that episode with those who you feel would benefit. Let me know what your thoughts are. And do you actually know what your operating profit margins are?

Until next time, happy calculating. We hope you enjoyed this episode and appreciate you taking the time to listen to the show. We hope you got some value. If you did, then we'd love it if you shared the episode. We look forward to you joining us next week for another I Hate Numbers episode.