Operating margin is used to determine the profitability of a business by measuring how much a company earns from sales-related activity.
Operating margin, also known as operating profit margin, is usually calculated as a percentage, and it measures the ratio of a business’s operating income to its return on sales.
Operating margin focuses on an intermediate step in the financial statement, and you can use it to zero in on the core elements of a business to see how profitable it is.
While gross profit margin, operating profit margin, and net profit margin are all measures that analyze business operations, operating profit margin focuses on indirect business expenses such as administrative costs, salaries, marketing costs, and depreciation costs.
Overview: What is operating margin?
In simpler terms, operating margin measures the profitability of a company by determining how much of each dollar of revenue received is left over after certain expenses are paid.
If you’re interested in learning how to calculate the operating margin for your company, it’s easy: Just take the company's operating income and divide it by its total revenue. The resulting percentage is the operating margin.
New business owners may be struggling to absorb the many concepts of accounting 101, but you or your bookkeeper can easily calculate your operating margin.
However easy the calculation may be, though, it doesn't tell you why operating margins are interesting. To understand that, it's helpful to look at what goes into getting you from total revenue to operating income.
The first step in calculating operating margin is to find your operating income, which is on your income statement. Your operating income is calculated by taking gross income and subtracting cost of goods sold, operating expenses, and depreciation and amortization.
For instance, Walker Printing had revenue of $150,000, its cost of goods sold was $55,000, and its operating expenses such as payroll, overhead, and research expenses were $50,00. Walker Printing would calculate its operating income as follows:
$150,000 - ($55,000 + $50,000) = $45,000
Operating income is then divided by total revenue:
Operating Income ÷ Total Revenue = Operating Margin
$45,000 ÷ $150,000 = $0.30 (or 30%)
This means for every $1 in sales that Walker Printing makes, it’s earning $0.30 after expenses are paid.
How to calculate operating income from total revenue
You need to calculate operating income in order to accurately calculate your operating margin. If you’re still confused about what to subtract from total revenue to find your operating income, keep reading.
Total revenue includes every penny a company receives from selling a product. It doesn't include any of the costs involved in generating business activity. Operating income includes some but not all of those costs.
1. Calculate cost of goods sold
The first thing the income statement does is calculate gross margin, or gross profit. You can do that by subtracting the direct cost of the goods or services the company sells. For instance, if a company sells lemonade, then the costs of lemons, water, and sugar are all a part of the cost of goods sold.
2. Calculate selling, general, and administrative (SG&A) costs
Next, you have to account for the ancillary costs of doing business. All companies have general overhead expenses, also referred to as selling, general, and administrative expenses. Items such as renting space for corporate offices, paying utilities, and hiring contractors to ensure your business complies with regulatory requirements are all examples of what can be included in general overhead.
3. Account for R&D and fixed assets
Companies also typically spend money on research and development. That expense gets taken out of revenue. Also, if a company has fixed assets that must be amortized or depreciated, the appropriate allowances are taken out at this point.
Subtract all of those items to find your operating income, from which you can then determine your operating margin.
What operating margin doesn't tell you
Knowing your operating margin is helpful, but it doesn't include every expense a company bears. For instance, interest income and expenses aren't included in operating income, though they are included in operating cash flow.
In addition, items of income or loss from foreign exchange impacts also get taken out further down on the income statement. One-time restructuring, impairment, and other charges are typically missing from operating income, too, as are income tax expenses.
Still, knowing your operating margin is useful for two purposes:
- Comparing operating margins for the same company from two different time periods will give you a sense of any progress or erosion in improving profitability.
- Comparing operating margins across various companies in the same industry can be helpful in figuring out which company takes better advantage of opportunities.
Operating margin is a simple concept, but it carries a lot of information. By inviting you to take a deeper look at your financial statement, in particular your income statement, operating margins can serve a valuable purpose.
Why is operating margin important for small businesses?
Operating margin is an important measurement for businesses of any size, including small businesses. Operating margin measures profitability, with a higher operating margin indicating that your business is performing well and considered financially sound.
In addition, a higher operating margin indicates that a business can better survive market challenges or an economic crisis.
Operating margin is also an important metric for creditors and investors, because it clearly illustrates how strong a company is financially and how profitable its operation is.
A higher operating margin indicates that the company is earning enough money from business operations to pay for all of the associated costs involved in maintaining that business.
For most businesses, an operating margin higher than 15% is considered good. It also helps to look at trends in operating margin to see if past years indicate that operating margin is going up or down.
For instance, let’s look at the operating margin over the last three years for the Walker Printing example from above:
- 2017 operating margin = $0.36, or 36% margin
- 2018 operating margin = $0.32, or 32% margin
- 2019 operating margin = $0.30, or 30% margin
While a 30% margin is good, you can see by looking at the last three years that Walker Printing’s operating margin has been declining. This indicates that Walker Printing needs to look at operational costs to determine if it should make changes in order to keep its operating margin from declining next year.
Operating margin and your business
No matter which accounting method you’re using, you can calculate operating margin. Calculating operating margin provides business owners with another measure of profitability, and it can point out potential trouble spots, making it an important measurement for all business owners.
If you’re looking for accounting software that can help you produce accurate financial statements, be sure to check out The Ascent’s accounting software reviews.
