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What Is Operating Margin?
Operating margin is a measure of a company's profit on a dollar of sales, after accounting for the variable costs of production—such as wages and raw materials—and before deducting interest expenses or taxes. It is also known as operating profit margin, operating income margin, return on sales, or EBIT (earnings before interest and tax) margin.
Operating Margin Formula
You arrive at your company's operating margin by dividing your operating profit by net sales (or revenues). The operating margin is expressed as a percentage, generally interpreted as the percent of each dollar of sales.
Operating profit / Revenue = Operating margin
- Operating profit—sometimes called operating income—is an accounting figure representing the amount of profit realized after deducting operating costs—the operating expenses (OPEX), such as wages and raw materials, and the cost of goods sold (COGS), such as the rent of a production facility—as well as amortization and depreciation. (OPEX also includes "selling, general and administrative expenses" [SG&A], which comprise all of a company's selling expenses, as well as its general and administrative expenses.)
- Revenue—sometimes called sales or net sales—is the total value of a company's sales of goods and services.
Operating margin does not account for a company's capital investments, which are not part of the costs of operating its core business.
As an example: A company's operating profit is $1,300, and its revenue is $13,000. Its operating profit margin is 10 percent, representing 10 cents out of every dollar of sales.
How to Use Operating Margin in Business
You can use your operating margin to make decisions about how to allocate your company's operational resources over differing revenue projections to optimize your income.
You can also use your operating margin to assess which expenses contribute most effectively to your company's bottom line.
But you’re not the only one interested in your operating margin.
- Your investors pay close attention to it, too, because it tells them how you’ve been spending money to bring in every dollar of sales, and whether that margin is growing or shrinking.
- Analysts look at your operating margin as an indicator of how much you can pay both your equity investors and your debt investors, as well as how much you have left to pay taxes.
- Analysts also use it to assess your stock value: Higher is better, all things being equal.
- Your operating margin also provides a useful benchmark to measure your company against your competitors in the same industry. The higher your margin, the more likely you’re a top performer in your industry.
Operating margins differ widely from one industry to another, so the metric proves less useful for comparing companies across industries.
Operating margin affords managers insight into the effectiveness of their decisions, as it directly reflects many of the variable costs that managers control but isn't affected by costs that they can't, such as interest or taxes.
If a company's operating margin varies widely over time, it's a red flag about risk. It can also reveal whether a good quarter is an anomaly or a sign of an upwards trajectory.
If a company’s operating margin decreases steadily over time, it indicates that costs and expenses are rising faster than sales, a sign of a company's bad health.
Operating Margin vs. Gross Margin
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Operating margin differs from gross margin, though both represent how efficiently a company generates income.
The two metrics differ in how they reflect the effect of costs and expenses on an income statement.
Operating margin does not reflect interest expenses—the cost of financing a business—or taxes on financial statements. As such, it helps a company decide whether it can afford to take on additional interest expense in the form of financing for expansion or capital expenditures, for example.
Potential investors may also find operating margin as a more useful metric to compare two companies in the same industry, with similar business models and annual sales: the one with the higher operating margin looks more efficient.
Gross margin—also called gross profit margin—is a percent measure that reflects only the costs directly related to the production and distribution of a company's goods or services. In other words,
Gross margin = Revenue — The cost of goods sold (COGS) / Revenue
Gross profit margin generally exceeds operating margin because it reflects the effects of fewer expenses (notably administrative costs, SG&A, amortization and depreciation). The metric is more useful to managers trying to make decisions about variable costs associated with production, such as wages, rent, and equipment leases.
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