An operating margin measures corporate profitability by calculating the ratio of operating income and net sales revenue. It’s also known as operating income margin, operating profit margin, earnings before interest and taxes (EBIT) margin, or return on sales (ROS).
Businesses calculate operating margin by deducting the cost of goods sold (COGS), operational, depreciation, and amortization costs from net sales. Accounting software calculates and analyzes operating margins to help businesses visualize real-time income on each dollar of sales revenue.
A company’s operating margin indicates core business profitability and enables stakeholders to evaluate the organization’s ability to pay fixed costs, such as interests and taxes. The operating margin is also crucial for businesses looking to optimize resource allocation based on revenue projections.
The operating margin formula helps companies measure the overall business health and profitability of core operations. Business managers consider operating profit margin in conjunction with free cash flow, net profit, and gross profit.
Operating profit margin = (Operating earnings - Net sales revenue) X 100%
Operating earnings refer to the profit that businesses make after different expenses, such as COGS, general and administration (G&A) expenses, depreciation, marketing, research and development, and other operating costs. Operating earnings help businesses identify net income before interest and taxes during a specific period.
Net sales revenue is total revenue or gross sales minus sales returns, discounts, and allowances. The net sales figure appears under direct costs in an income statement and is vital for an organization’s top-line growth.
Operating margins vary across industries because of different competition levels, scale efficiencies, and capital structures. Operational efficiencies vary across sectors, and so do operating margins. That’s why it’s unfair to compare two different industries.
An excellent operating margin increases over time while staying positive. Companies striving to attain superior operating margins must improve unit economics, stay competitive, and relevant.
A healthy operating margin is essential for financial stability. Companies with higher operating margins are less likely to be at risk and will continuously seek to improve profit margins. These organizations use the following practices to increase their operating profit margins.
The operating margin evaluates operations efficiency by finding company profits after variable costs payment. This metric doesn’t take into account interests or taxes. Businesses looking to improve operating margins utilize resources efficiently, work on product pricing, and refine management controls.
The gross profit margin is the ratio of gross profit and total revenue. Gross margin analysis is an effective way to understand production efficiency and gross profit per dollar of revenue. Product-based companies analyze gross margin periodically to understand improvement or erosion of product margins over time.
The net profit margin measures net income or profit per dollar of revenue. This metric is an excellent benchmark for evaluating a company’s ability to generate profit from sales and contains both overhead and operating costs.