Operating margin measures the profitability of a company’s core operations after accounting for operating expenses and cost of goods sold (COGS). Because operating margin is expressed as a percentage of sales, rather than an absolute dollar figure, it is a useful tool for comparing the profitability of different companies within the same industry and measuring profitability trends over time. It’s also used by creditors and investors to make lending and investment decisions.
What Is Operating Margin?
Operating margin is the ratio of operating income to net sales revenue, expressed as a percentage. Operating margin is also known as operating profit margin and return on sales. It shows how much operating income is generated from each dollar of sales revenue.
Operating income is an intermediary step on a company’s income statement. Operating income (or loss) is the profit (or loss) from net sales after deducting COGS and operating expenses. Operating margin is the “common size” metric derived from operating income. Common size metrics are expressed as percentages of sales, making it easier to compare companies of different sizes.
Calculating Operating Margin
Operating margin is calculated from two other key financial metrics: net sales revenue and operating income. All the required information can be found on a company’s income statement. It’s important to use accurate data that has been prepared using consistent accounting methods, especially when doing comparative analysis. Companies can calculate operating margin over any length of time, such as monthly, quarterly or annually. Companies commonly also calculate the operating margin for specific business units and product lines. This enables them to compare the profitability of different parts of the business.
What Is Sales Revenue?
Sales revenue is the value of all product and service sales. Companies typically report either gross or net sales revenue on their income statement. Gross sales revenue includes all cash and credit sales, depending on the company’s accounting method. Net sales revenue is gross sales minus returns and certain after-sale allowances and discounts, such as early-payment discounts. Net sales revenue is the starting point for calculating operating income and operating margin.
The terms “revenue” and “sales” are often used interchangeably. However, under Generally Accepted Accounting Principles (GAAP), a set of accounting rules issued by the Financial Accounting Standards Board (FASB), revenue is a broader term that includes other sources of income in addition to sales.
What Is Operating Income?
Operating income, as defined by GAAP, is the profit from net sales after deducting COGS and operating expenses. For a manufacturing company, COGS comprises expenditures directly tied to the production of goods, such as the cost of raw materials, manufacturing personnel payroll and freight-in. In a service industry, the comparable measure is cost of sales, which includes the direct costs of providing the services delivered to customers. Operating expenses include other costs associated with day-to-day operations, such as sales commissions, administrative costs, depreciation and amortization of assets used for core operations.
By definition, operating income excludes non-operating revenue and expenses, which are generated by non-operating activities and one-time gains and losses. For example, operating income doesn’t include investment income, one-time payouts, gains on disposal of equipment, impairment of intangible assets and financing costs. Income tax is another key exclusion from operating income.
If a company does not have any non-operating activities, operating income may be the same as earnings before interest and taxes (EBIT). Operating income can be calculated using one of the following formulas:
1. Operating Income = Net Sales Revenue - COGS - Operating Expenses
2. Operating Income = Net Income + Interest Expense + Taxes
Operating Margin Formula
To compute operating margin, divide the operating income by net sales and multiply by 100. The formula is:
Operating Margin = Operating Income / Net Sales Revenue x 100
For example, say a company reported on its 2020 annual income statement a total of $100 million in net sales revenue. Total COGS and operating expenses for the year were $60 million, resulting in operating income of $40 million. Its operating margin is 40% ($40 million/$100 million x 100).
What Does Operating Margin Tell You?
Operating margin tells you how efficiently a company generates profit from its core operations. That’s because it includes only COGS and operating expenses; it excludes non-operating costs such as interest payments and taxes. Because operating margin expresses profitability as a percentage rather than in dollar terms, it’s useful for comparing companies. For example, it can be used to compare a company with competitors that have higher or lower sales revenue and operating income. Comparing operating margins excludes the effect of company size; it shows how much profit each company makes on every dollar of sales revenue.
Is Operating Margin the Same as Profit Margin?
Operating margin is one of three widely used profit ratio metrics. The others are gross margin and net profit margin. Each of these metrics provides a different perspective on a company’s business.
Gross margin, also known as gross margin ratio, is the ratio of gross profit to sales revenue. Gross profit is sales revenue minus COGS, so the gross margin tells you how profitable the company is after deducting only the direct costs of production. In contrast, operating margin takes into account operating expenses as well as COGS.
Net profit margin is the ratio of net income to sales revenue. Net income is the company’s profit after deducting all operating and non-operating expenses, including interest and taxes.
Importance of Operating Margin
First and foremost, operating margin shows how well a company derives profits from its core business after covering fixed and variable expenses. Those profits can be used to fund business growth or returned to the company’s owners.
A company’s operating margin is a good indicator of how well it is managed. A well-managed company typically does a good job of maximizing revenue while controlling costs in areas such as administrative salaries and rent, which are typically major components of operating expenses. A company’s ability to improve operating margin over time can be a sign of its overall health and competitiveness.
Is a Lower or Higher Operating Margin Better?
Higher operating margins are generally better than lower operating margins — but the definition of “good” depends on which industry you’re in. Some industries have inherently higher operating costs than others, so it’s important to compare companies within the same sector.
Comparing operating margins to industry benchmarks can be more useful than considering them in isolation. For example, supermarkets and grocery stores have extremely slim operating margins averaging just over a few percentage points They generally rely on high sales volumes to generate enough profit in dollar terms. In contrast, the average operating margin in the advertising sector is around 12%, and among utilities it’s around 17%.
Benefits of Operating Margin
Analyzing operating margin can be beneficial in several ways. Companies can use this metric to assess their own operations, compare profitability with other companies, and help to set pricing.
- Industry comparisons: A company can compare its operating efficiency to others in the same industry, excluding factors such as taxes that are outside the company’s control.
- Efficiency analysis: Analysis of operating margin and its components may help a company uncover opportunities to reduce or eliminate expenses.
- Trend analysis: Tracking operating margin over time can help a company identify profitability trends and produce more accurate forecasts.
- Pricing strategies: Operating margin analysis can be helpful in setting pricing.
Limitations of Operating Margin
While operating margin is a key profitability measure, it has a few notable limitations. By definition, operating margin excludes certain costs that can have significant impact on a company’s financial position even though they are outside of core operations. These include income taxes, the cost of servicing debt, litigation payouts or losses on investments. Similarly, operating margin also excludes opportunities for ancillary profits, such as investment income or gains on the sale of assets.
Another important limitation of operating margin is that it is disconnected from cash flow, which can be a critical factor in a company’s survival. A company may have a solid operating margin but still face cash flow problems, for example if it has difficulty collecting cash from a major customer. In fact, many apparently profitable companies have gone out of business due to insufficient cash flow and working capital.
Other Uses for Operating Margin
Operating margin is helpful for analyzing the quality of a company’s earnings, because it strips away ancillary activities and focuses on the profitability of core operations. Lenders and investors therefore analyze operating margin, together with other metrics, to determine the risk involved in lending to or investing in a business. For example, a lender may consider operating margin as an indicator of whether a business will be able to make regular payments on loans. Similarly, an acquirer considering a leveraged buyout might analyze operating margin to assess the company’s ability to generate profit and repay the new debt that’s generally created as a result of the acquisition. Investors utilize operating margin as part of the financial modeling to evaluate potential returns on their investment.
Using Accounting Software for Operating Margin Analysis
Accounting software can be used to analyze operating margins as part of a broader approach to management accounting, which is a strategic form of accounting that combines operational metrics and other business information to support business decisions. To accurately calculate and analyze operating margin, look for accounting software that integrates data from across the company and provides flexible reporting including dashboards with real-time metrics.
Operating margin is a useful measure of a company’s profitability and its ability to cover fixed expenses such as interest payments on loans. It’s also useful for comparing operating performance with companies in the same industry, because it measures the profitability of core operations excluding costs such as taxes and interest. However, operating margin has limited value as an indicator of overall business health, because it excludes those non-operating costs and because it doesn’t measure cash flow. For this reason, managers should assess operating margin in conjunction with other metrics, such as net and gross profit margin and free cash flow.