Why you need to pay close attention to operating profit

Julie Brownlee, Fsp Invest, 24 Jun. 2014

Tags: operating profit, operating margins, profit, company profit, what is operating profit, operating margin, investing

Having a look at a company’s accounts can be a bit mind boggling. Who would have thought there could be so many different types of profit? One of the most quoted types of profit is operating profit. So what is operating profit? And what does operating profit tell you about a company? Read on to find out…

What is operating profit?

Operating profit takes into account the costs a company incurs to produce its product.

To calculate a company’s operating profit, firstly you need to look at a company’s indirect costs or overheads. These include things like rent and salaries of office staff, Tim Bennett in Money Week explains.

Indirect costs tend to be pretty stagnant figures. Regardless of what’s going on with the sales side of the company, the indirect costs stay pretty much the same.

Operating profit also includes direct costs, such as the costs incurred from making the product.

If a company has a good operating margin, it means the business is making good money. This is before you take any funding costs into account. Funding costs include things like dividends paid to shareholders and interest payments made to the bank.

When delving through a company’s accounts and you see operating profit dipping, what does it mean for the company? Well it depends on the situation.

Let’s take a look at a couple of examples…

The impact of changes to operating margins

A diamond ring maker sells 100 rings for R10,000 each. His operating margin is 50%. Overall sales come in at R1 million. Operating profit comes in at R500,000.

A cap retailer sells 1 million caps for R10 each. His operating margin is 50%. As with the diamond ring maker, that brings the overall sales to R1 million and the operating profit to R500,000.

For both the diamond ring maker and the cap retailer, their operating margins shrink by 3%. Let’s see what that does to operating profits…

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The operating profit of the ring maker falls to R470,000 (100 x R4,700). But for the cap retailer, the operating profit slumps to R200,000 (1 million x R10 x 0.02).

This example shows why it’s so important to watch the operating margins in businesses of high volume and low margins. This includes businesses such as food and clothing retailers.

So there you have it, why you need to pay so much attention to operating profit.

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