How to Calculate Your Operating Margins (2024)

Operating margin measures the profitability of a company’s core operations afteraccountingfor operating expenses and cost of goods sold (COGS). Because operating margin is expressedas a percentage of sales, rather than an absolute dollar figure, it is a useful tool forcomparing the profitability of different companies within the same industry and measuringprofitability trends over time. It’s also used by creditors and investors to makelendingand investment decisions.

What Is Operating Margin?

Operating margin is the ratio of operating income to net sales revenue, expressed as apercentage. 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. Operatingincome(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 sizemetrics are expressed as percentages of sales, making it easier to compare companies ofdifferent sizes.

Calculating Operating Margin

Operating margin is calculated from two other key financial metrics: net sales revenue andoperating income. All the required information can be found on a company’s incomestatement.It’s important to use accurate data that has been prepared using consistent accountingmethods, especially when doing comparative analysis. Companies can calculate operatingmargin over any length of time, such as monthly, quarterly or annually. Companies commonlyalso calculate the operating margin for specific business units and product lines. Thisenables them to compare the profitability of different parts of the business.

What Is Sales Revenue?

Sales revenue is the value ofall product and service sales. Companies typically report either gross or net sales revenueon their income statement. Gross sales revenue includes all cash and credit sales, dependingon the company’s accounting method. Net sales revenue is gross sales minus returns andcertain after-sale allowances and discounts, such as early-payment discounts. Net salesrevenue is the starting point for calculating operating income and operatingmargin.

The terms “revenue” and “sales” are often used interchangeably.However, under Generally AcceptedAccounting Principles (GAAP), a set of accounting rules issued by the FinancialAccounting Standards Board (FASB), revenue is a broader term that includes other sources ofincome in addition to sales.

What Is Operating Income?

Operating income, as defined by GAAP, is the profit from net sales after deducting COGS andoperating expenses. For a manufacturing company, COGS comprises expenditures directly tiedto the production of goods, such as the cost of raw materials, manufacturing personnelpayroll 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 expensesinclude 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 aregenerated by non-operating activities and one-time gains and losses. For example, operatingincome doesn’t include investment income, one-time payouts, gains on disposal ofequipment,impairment of intangible assets and financing costs. Income tax is another key exclusionfrom operating income.

If a company does not have any non-operating activities, operating income may be the same asearnings before interest and taxes (EBIT). Operating income can be calculated using one ofthe 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 = OperatingIncome / Net Sales Revenue x 100

For example, say a company reported on its 2020 annual income statement a total of $100million in net sales revenue. Total COGS and operating expenses for the year were $60million, resulting in operating income of $40 million. Its operating margin is 40% ($40million/$100 million x 100).

What Does Operating Margin Tell You?

Operating margin tells you how efficiently a company generates profit from its coreoperations. That’s because it includes only COGS and operating expenses; itexcludes non-operating costs such as interest payments and taxes. Because operating marginexpresses profitability as a percentage rather than in dollar terms, it’s useful forcomparing companies. For example, it can be used to compare a company with competitors thathave higher or lower sales revenue and operating income. Comparing operating marginsexcludes the effect of company size; it shows how much profit each company makes on everydollar 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 profitmargin. Each of these metrics provides a different perspective on a company’sbusiness.

Gross margin, also known as gross margin ratio, is the ratio of gross profit to sales revenue. Gross profit is salesrevenue minus COGS, so the gross margin tells you how profitable the company is afterdeducting only the direct costs of production. In contrast, operating margin takes intoaccount operating expenses as well as COGS.

Net profit margin is the ratio of net income to sales revenue. Net income is thecompany’sprofit after deducting all operating and non-operating expenses, including interest andtaxes.

Importance of Operating Margin

First and foremost, operating margin shows how well a company derives profits from its corebusiness after covering fixed and variable expenses. Those profits can be used to fundbusiness growth or returned to the company’s owners.

A company’s operating margin is a good indicator of how well it is managed. Awell-managedcompany typically does a good job of maximizing revenue while controlling costs in areassuch as administrative salaries and rent, which are typically major components of operatingexpenses. A company’s ability to improve operating margin over time can be a sign ofitsoverall health and competitiveness.

Is a Lower or Higher Operating Margin Better?

Higher operating margins are generally better than lower operating margins — but thedefinition of “good” depends on which industry you’re in. Some industrieshave inherentlyhigher operating costs than others, so it’s important to compare companies within thesamesector.

Comparing operating margins to industry benchmarks can be more useful than considering themin isolation. For example, supermarkets and grocery stores have extremely slim operatingmargins averaging just over a few percentage points They generally rely on high salesvolumes to generate enough profit in dollar terms. In contrast, the average operating marginin 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 metricto assess their own operations, compare profitability with other companies, and help to set pricing.

• Industry comparisons: A company can compare its operating efficiency toothers in the same industry, excluding factors such as taxes that are outside thecompany’s control.
• Efficiency analysis: Analysis of operating margin and its componentsmay help a company uncover opportunities to reduce or eliminate expenses.
• Trend analysis: Tracking operating margin over time can help a companyidentify profitability trends and produce more accurate forecasts.
• Pricing strategies: Operating margin analysis can be helpful in settingpricing.

Limitations of Operating Margin

While operating margin is a key profitability measure, it has a few notable limitations. Bydefinition, operating margin excludes certain costs that can have significant impact on acompany’s financial position even though they are outside of core operations. Theseincludeincome taxes, the cost of servicing debt, litigation payouts or losses on investments.Similarly, operating margin also excludes opportunities for ancillary profits, such asinvestment 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 acritical factor in a company’s survival. A company may have a solid operating marginbutstill face cash flow problems, for example if it has difficulty collecting cash from a majorcustomer. In fact, many apparently profitable companies have gone out of business due toinsufficient cash flow and working capital.

Other Uses for Operating Margin

Operating margin is helpful for analyzing the quality of a company’s earnings, becauseitstrips away ancillary activities and focuses on the profitability of core operations.Lenders and investors therefore analyze operating margin, together with other metrics, todetermine the risk involved in lending to or investing in a business. For example, a lendermay consider operating margin as an indicator of whether a business will be able to makeregular payments on loans. Similarly, an acquirer considering a leveraged buyout mightanalyze operating margin to assess the company’s ability to generate profit and repaythenew debt that’s generally created as a result of the acquisition. Investors utilizeoperating margin as part of the financial modeling toevaluate 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 approachto management accounting, which is a strategic form of accounting that combines operationalmetrics and other business information to support business decisions. To accuratelycalculate and analyze operating margin, look for accounting softwarethat integrates data from across the company and provides flexible reporting includingdashboards with real-time metrics.

Operating margin is a useful measure of a company’s profitability and its ability tocoverfixed expenses such as interest payments on loans. It’s also useful for comparingoperatingperformance with companies in the same industry, because it measures the profitability ofcore operations excluding costs such as taxes and interest. However, operating margin haslimited value as an indicator of overall business health, because it excludes thosenon-operating costs and because it doesn’t measure cash flow. For this reason,managersshould assess operating margin in conjunction with other metrics, such as net and grossprofit margin and free cash flow.