Operating profit / Operating margin
In accounting, Operating profit is an income statement term for a company's reported income, before factoring in taxes, extraordinary items, or other non-operating gains and losses. Operating profit, in other words, is the reported profit from the company's normal business operations. Operating profit expressed as a percentage of Net sales revenues is called Operating margin.
Note that it is possible for the company to show a positive operating profit, yet have a negative bottom line Net Profit. This situation sometimes occurs when the comapany has large extraordinary cost items during the period (see the Income Statement Example, below).
In financial accounting, moreover, profits and margins refer to three specific income statement results: gross profits, operating profits, and net profits. Analysts and management look to these ptogidy snf margins as measures of the company's earning performance.
Operating profit, Operating Margin, and the other income statement profits are defined and illustrated in the context of related concepts in the sections below:
• Margin from the Seller's Viewpoint
• Margins as Income Statement Profits
• Example Income Statement
• Three Kinds of Margins (Three Kinds of Profits)
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Margin from the Seller's Viewpoint
Sellers (vendors) generally refer to margin as the difference between their cost for an item and the selling price. An item for which they pay $60 to their supplier, but which they sell for $100, has in this sense a $40 margin.
Margin in this sense refers to margin on the item, but does not include the seller's overhead costs for such things as store leasing fees, nor does it include general overhead costs for such things as management salaries. Here, the term margin is very close in meaning to what accountants call gross margin (see following sections). When the genral and overhead costs are also subtracted from sales revenues, the result is the merhant's operating profit.
Sellers, large and small, have a keen interest in knowing their gross margin on individual products. On the one hand, they may be quite willing to sell low gross margin products if these sell in high volume, or if they leverage sales of higher margin products. On the other hand, with lower volume sales or the absence of product-to-product leverage, they will want to concentrate selling resources on the higher margin products
Margins as Income Statement Profits
The term margin, when used in accounting and financial reporting, refers to any of three "profit" lines on the income statement. A margin, specifically, is a profit figure expressed as a percentage of the company's net sales revenues. This section and the next show how the income statement presents three profit figures (gross profit, operating profit, and net profit), and the following section shows how these are used as margins.
The income statement is a financial statement that reports a company's income for a period of time, usually for a fiscal quarter or fiscal year. Income is thus a measure of the company's earning performance for a specific period. The income statement heading will so indicate with a phrase such as
- ". . . for the year ended 31 December 2011," or
- ". . . for the quarter ended 31 June 2011."
This contrasts with the balance sheet, which shows the status of assets, liabilities and owner’s equities at one point in time.
Note that income is also called "profits," "earnings," or, less formally "the bottom line," referring to its usual position on the income statement. However, "profit" refers to a company's overall net profit (the bottom line), but also to "gross profit" and "operating profit" (see the example statement below and the section Three Kinds of Profits below.). In any case, also note that many people refer to the income statement as a "profit and loss" statement or "P&L"
Publically traded companies (those that sell shares of stock to the public) are required almost everywhere to report publically on financial performance and financial position, quarterly and annually. Privately held companies, however, may withhold such information from the public, from competitors, and from securities regulators (but not from tax authorities).
In principle, profit making companies exist and operate primarily to create value for their owners. The company's primary way of doing this is by earning income. Once income is declared there are essentially only two things the company can do with it:
- Declare all or part of the income as "retained earnings," which increases owner value by increasing owner's equity on the balance sheet.
- Distribute all or part of the income to the company owners (shareholders) as dividends—a more direct way to provide owner value.
The income statement generally shows how income figures result by subtracting the entity’s costs and expenses from its total sales revenues.
Income = All Revenues - All expenses and costs
Note by the way, that reported income, revenues, and expenses do not necessarily represent real cash inflows or outflows. This is because regulatory groups, standards boards, and tax authorities, allow or require companies to use conventions such as depreciation expense, allocated costs, and accrual accounting on the income statement. Actual cash flow gains and losses for the period are reported more directly on another reporting instrument, the Statement of Changes in Financial Position (or cash flow statement).
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Example Income Statement
The income statement is simply a detailed application of the income equation: Income = All Revenues – All expenses and costs. The example statement below might represent a manufacturing company, but the general form and major categories are typical for companies across a wide range of industries. A company that sells services rather than manufactured goods might report "Cost of services" rather than "Cost of goods sold," but aside from a few such minor differences in terms, the income statement structure is nearly universal.
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
Notice that expenses fall into five major categories. The first three categories represent expenses that come from the company's normal business:
• Cost of Goods Sold
The costs of producing goods or services
• Operating Expenses – Selling Expenses
The costs of selling the goods or services
• Operating Expenses – General and Administrative Expenses
Overhead, support, and management costs from across the company
G Note that depreciation expenses may appear in each of these categories, depending on what the assets in question are used for.
The remaining two major expense categories refer to both gains and losses from activities that are not in the company's normal line of business. This company is not, for instance, in the financial services, or financial investing, or lending business. The company is also not in the real estate business. Financial transactions in these latter areas must be reported separately from the areas that contribute to normal operating income.
• Financial Revenues and Expenses
These include revenues from invested funds and costs from financing
borrowed funds.
• Extraordinary items
These may include large gains or losses from selling land or major assets,
or from major actions restructuring the company (e.g., the expenses of laying off
part of the workforce).
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Three Kinds of Profits (Three Margins)
Bottom line net income is a measure of the company's financial performance for the period, but the income statement contains other performance metrics as well. The difference between net sales revenues and cost of goods sold is called Gross profits, for instance, while the net income from operations—before taxes and before gains and losses from financial and extraordinary items—is called operating income (or operating profits).
All three of the profit lines from the income statement (gross profit, operating profit, and bottom line net profit) can also be expressed as a percentage of net sales, that is, as margins. Gross profit, for instance is gross profit divided by net sales (see the table below):
Margins, in turn, are very important indicators of a company's performance for stock market analysts, and for the company's own management.
- Analysts will compare the company's margin percentages directly with margins from competitors and with industry "best in class" standards. They will consider not only the current margins, but also period-to-period trends in margins.
- The company's management attention will focus on margins for several reasons:
- First, margins are central to the company's business model. Margin's in the model, that is, show exactly where the company expects to make money.
- Secondly, management will watch closely year-to-year changes in margins. Margins are a highly sensitive indicator of the company's ability to compete effectively and reach objectives in its business plan.
- Thirdly, for individual product lines and even individual products are central to management planning and decision making in product portfolio management and other aspects of product planning. The income statement shows the gross margin, for instance, of the whole company, but underneath the company average gross margin (and shielded from competitors and public eyes), each product has its own gross margin as well. Only by knowing and managing the mix of individual product gross margins, can management optimize the overall product set gross margin.
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