How can your Operating Profit Margin help you? – Direct Costs & Overheads, part 3

In this series, we’re considering our financial statements, and what they can do for you to help you manage your small business. We’ve had a look at Direct Costs vs Overheads, and at the Gross Profit Margin.

In this post, let’s consider your Operating Profit Margin.

What is Operating Profit?

Operating Profit = Revenue – Direct Costs – Overheads – Depreciation – Amortization

(It’s close to your bottom line, which is net profit.

Net Profit = Operating Profit – Interest – Tax )

Let’s say your profit & loss report looks like this:

Revenue: £500,000

Direct Costs:  £250,000

Overheads: £125,000

Depreciation: £25,000

Amortization: £500

This gives us an Operating Profit of £99,500.

What is Operating Profit Margin?

Remember, “margin” in business metrics generally means it’s a percentage, or ratio. As before, this one is straightforward: Operating Profit Margin = Operating Profit Revenue Continuing with our example from above, our Operating Profit Margin is: 99,500 500,000 = 19.9% Higher percentages are better.

What is your Operating Profit Margin?

Grab your own Profit & Loss report. Calculate your own Operating Profit Margin.

Come back when you have.

What does it tell us?

The Operating Profit Margin tells us how efficiently your company manages its expenses (so as to maximize profit).

Many people believe that this margin is a good indicator of the strength of the company’s management team, since they often have more control over Overheads than Direct Costs (materials or stock). That is, this metric is used more often to look at management efficiency rather than Gross Profit Margin or Net Profit Margin.

What should you watch out for when comparing Operating Profit Margins?

Different approaches to depreciation (and amortization) will affect this. (Amortization spreads the cost of intangible assets; depreciation spreads the cost of tangible assets, as I’ve previously covered.) In the UK, each company decides its own policies about depreciation and amortization; these are not mandated from on high.

• Let’s say Acme Ltd capitalises individual pieces of equipment over £5k in value.
• Let’s say Coyote Ltd capitalises individual pieces of equipment over £1k in value.
• Let’s say both depreciate equipment 10% each year using a straight line method, just to keep it simple. That means they expect the equipment to last 10 years, and they’ll depreciate one-tenth of the cost price each year.

Let’s say both companies bought 30x machines this year, each £3,000, spending £90k in total.

• Acme Ltd will show a £9k expense on the profit and loss – just the 10% depreciation of those machines.
• Coyote Ltd will show a £90k expense on the profit and loss – the full cost of those pieces of equipment they bought this year.

Going back to the example we started with above, let’s say both companies have those figures before adding in these 30 machines. Let’s see what happens:

Both companies made the same sales and had the same expenses; let’s say they have the same amount of cash left in the bank at the end of the year.

Acme Ltd looks like it’s much more profitable – so it will pay more tax and shareholder dividends out of that same bank balance.

How can you improve your Operating Profit Margin?

You can use the same 2 levers that I discussed in the last post, around decreasing your Direct Costs and increasing your Sales. In addition, you can:

3. Decrease your depreciation or amortization

Technically, this is a lever, but you shouldn’t do it.

It’s not possible at all if your company has already created its capitalisation policy. This is usually only a possibility for a brand new company.

Even then, you would need to consider it with great care.

Decreasing your depreciation doesn’t actually put more money in the bank – and you’re still on the hook for the tax.

How might this look in practical terms?

You could decide to depreciate equipment over 15 years instead of 10 so that each year’s depreciation expense is less.

However, if the machines still only last you 10 years, then when you replace them at year 10, you end up having a bigger whack on your expenses than every other year.

Continuing the above example, instead of £90k becoming £9k per year for 10 years, you would instead see an expense of £6k per year for 15 years.

But then, in year 10, when you end up taking the machines to the tip anyway, you’d get an expense of £30k that year.

It’s best to use as realistic figures as possible at all times, to have the clearest picture of how your business is doing. That’s what all your financial statements and management accounts are there for – to give you a true idea of how it’s doing.

It’s also required by the accounting standards your accounts must adhere to, and undoubtedly required by the code of ethics of your accountant’s professional body to use the most realistic figures possible.

4. Decrease your overheads

Remember when I mentioned that Operating Profit Margin is seen as a good indicator of the management of the company? This is the lever that idea is focused on.

Your overheads are everything that isn’t directly attributable to producing whatever you sell.

Materials, the labour to turn that into finished goods, and stock bought to resell are Direct Costs.

Rent, insurance, packaging, admin, regulatory fees, advertising, and everything else are Overheads.

All of us in business must spend money to make money; make sure you’re getting good return on investment for all these overheads.

Conclusion

In this post, we’ve looked at:

• What the Operating Profit is
• What the Operating Profit Margin is
• What it tells us
• How depreciation can impact it
• How you can improve it

Hopefully, you’ve spotted at least one action point to take away and apply today in your own business.

I’ll see you next week to discuss another way to use these numbers to manage your small business better.

The Direct Costs and Overheads Series

What are direct costs vs overheads?

How can your Gross Profit Margin help you?

How can your Operating Profit Margin help you?

How can your Stock Turnover Ratio help you?