Home Plumbing Contractor Free Plumbing and Heating Contractor Business Strategy Questionnaire 8.7 Operating Profit Margin Analysis Questionnaire
What is the Operating Profit Margin ratio and why is it important in a business plan for a Plumbing and Heating Contractor?
The Operating Profit Margin for a small business like Central Plumbing & Heating Inc. is the Operating Income divided by the Sales of the business. In the world small business the earnings before income and taxes is used as the operating income. This ratio computes how much money the business has left over to pay for the interest on its loans and taxes and it gives a small business owner like Felix Gonzalez the ability to explain to the reader of the business plan just what kind of cushion the business has to pay its creditors.
This is of course an important profitability ratio since a lender like a bank will look to see just how much money a business like Central Plumbing & Heating Inc. is generating and if they will or will not be able to pay off their loan comfortably. Very often in the case of startup businesses, it is quite possible that a small business owner will have to forecast losses for the first couple of years and in that case, the business plan will be carefully scrutinized by lenders and possible partners to see how the business will be able to come up with the money to pay their loan if their operating profit margins are not healthy.
Operating Income is calculated by starting with the Gross Profits and subtracting the Opeating expenses from them.As a general rule, the higher the operating profit margin ratio the better it is for the company since it denotes that the company has plenty of cushion to meet its fixed obligations like mortgages, business loans etc. Operating Profit Margins are also very commonly used in comparative ratio analysis by banks and potential partners when they are comparing the viability of lending or partnering up with one business versus another.
What does a declining Operating Profit Margin ratio indicate to a small business owner like Felix Gonzalez?
A decrease in the Operating Profit Margin ratio for a small business like Central Plumbing & Heating Inc. could come about either because the operating expenses of the small business have increased and / or the revenues or sales of for the business have decreased. In the event the sales have remained constant and the operating expenses of a small business like Central Plumbing & Heating Inc. have increased, a small business owner like Felix Gonzalez will have to take a hard look at why there has been an increase in the operating costs - it could well be because of the hiring of additional employees, or the increase in rent or the addition of a new facility requiring an additional rent and employees and other operating expenses.
However an increase in these operating expenses have to sooner or later translate into an increase in revenues. Thus for every $100 in sales if you were taking in $15 worth of operating income with $85 going towards operating expenses and now you are taking in $10 worth of operating income with $90 going towards operating expenses, your Operating profit margin just fell from $15% to 10%. As a small business owner you will need to understand why your operating expenses went from $85 to $90 and keep a sharp lookout for a further increase in costs.
One of the biggest mistakes that we have seen small business owners like Felix Gonzalez make is that as they see business pick up, they tend to start expanding their operational infrastructure and taking on expense in the anticipation of greater revenues down the line; later when those revenues don't materialize they get caught in a cash crunch and invariably run into difficulty. The Operating Income margin ratio is an early indicator of just that kind of trouble and we recommend that is be used to understand the changing nature of profitability in a small business like Central Plumbing & Heating Inc..
Besides an increase in the operating expenses causing a reduction in the operating income, another reason why the Operating Profit Margin ratio could be going down is of course because of a decline in sales. If the sales for a small business like Central Plumbing & Heating Inc. are going down, then it indicates that there is now less cushion for the business to cover its operating expenses and therefore it has less money left over to pay its interest costs and taxes. In these circumstances, a business owner like Felix Gonzalez may well have to cut costs to bring them in line with the reduced revenues.
Alternatively, Felix Gonzalez could come up with a better sales strategy to jump start lagging sales numbers and bring those in line with the operating expenses structure of the business.
Does a higher Operating Profit Margin ratio give a small business like Central Plumbing & Heating Inc. an advantage over its competitors?
Yes. If Central Plumbing & Heating Inc. has a higher Operating Profit Margin ratio than the competition, it means that Central Plumbing & Heating Inc. has a better cost structure and / or is generating more revenues than the competition. That means that it will be able to ride out the slower economic times much better than the competition since it has more cushion to operate under and still pay its fixed obligations like loans and notes. On the other hand, competitors with higher cost strcutures and lower Operating Profit Margin ratios have very litte room to maneuver.
Since they are operating with such thin cushions, any sudden slowdown in their business could land them in trouble since they will not be able to meet their obligations - we cannot emphasize this point enough - most established businesses don't go out of business because of market forces but instead they tend to go out of business because of very high operating cost structures.
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