|The next key income statement item is operating margin, which measures the profitability of core business operations.|
Calculating the net operating income is done by deducting expenses that are necessary for operating the business, such as advertising, rent, and wage expenses, but before deducting interest and income tax expenses. For this reason net operating income is also called EBIT (earnings before interest and income taxes). EBIT is a measure of a company’s profitability from operations.
As a percentage of sales, net operating income is called operating profit margin, or operating margin:
Calculating Operating Margin
|Operating Profit Margin = Net Operating Income/Sales|
Operating profit margin is a key measure of how effective a company is at controlling the costs and expenses associated with its normal business operations.
Notice that payroll taxes are part of operating expenses, but income taxes are not. This is because payroll taxes are directly related to the wages paid to employees for operating the business.
Income taxes, on the other hand, are taxed on the final income of the business, and are not directly contributing to operations for the business.
Sunny has an operating profit margin of 12.2%.
How efficiently is Sunny operating Sunny Sunglasses Shop in comparison to other industry averages?
Operating Profit Margins by Industry
Operating Profit Margin
|Sunny Sunglasses Shop||12.2%
|Sunglasses Hut Int. (Luxottica Group)||10.9%|
|Specialty Retail, Other||8.7%|
Sunny Sunglasses Shop operating margin is higher than the average operating margin of its closest competitor, Luxottica Group, as well as the industry average, Specialty Retail.
The software industry is used as an example to illustrate strong industry profitability. Software companies can sell more product very inexpensively once produced, and can increase sales with lower selling costs than many industries.
The S&P 500 is an average of 500 successful large cap companies traded on the New York Stock Exchange or NASDAQ that can help us gauge how our profit margins are stacking up against a broad base of other highly successful companies. It can thus be used as a guide to select an industry and business with higher than average profit margins.
Sunny’s focus now is on staying profitable against the competition in the Specialty Retail Industry. Sunny has managed to stay pretty closely in line with the operating margins of his closest and most successful competitor.
Nevertheless, Sunny can still look for ways of increasing sales while maintaining low operating costs, thus increasing operating margins against the competition. Increasing sales while maintaining low operating costs is the key to operating profitability.
The 80/20 Principle
This is a good time to take a look at the 80/20 Principle and apply it to your business.
Vilfredo Pareto, an economist who lived from 1848-1923, devised a mathematical formula to demonstrate that 80% of wealth comes from 20% of the population. This principle could also be applied outside economics to just about anything. In fact, 80% of Pareto’s garden peas were produced by 20% of the peapods planted!
Now apply this to a company’s product line. 80% of a company’s revenue comes from 20% of the products. Companies like Microsoft and Apple understand this principle. Software products such as Windows and Office, or hardware products such as the iPhone, iPod, and MacBook, account for 80% of a company’s profit, but represent a much smaller percentage of products offered.
How does this apply to the income statement and operating income?
Because the 80/20 Principle can also apply to revenue and expenses. Roughly 80% of your sales may come from 20% of your products. Similarly, 80% of your sales may be supported by 20% of your expenses.
In addition to tracking which products are contributing the most to revenue, Sunny may want to investigate what expenses contribute to the sales of top performing products, and what expenses can be scaled down without having a large impact on his sales.
For example, it is very likely that a small percentage of his advertising expenses of $3,400 are generating much more of the sales. Is advertising to a certain demographic or in a certain medium more effective than others? Are there significant expenses incurred for supporting lower performing products?
Using this kind of analysis can affect both sides of the operating margin equation by increasing sales, and reducing or eliminating those expenses that are not effectively contributing to the bottom line.