What is operating margin?
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.
Importance of operating margin
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.
How do stakeholders use operating margins to make decisions?
- Investors: Identify growing or shrinking margin and spending patterns
- Analysts: Evaluate the stock value, and a company’s ability to pay equity and debt investments
- Senior leadership team (SLT): Uses operating margin as a benchmark to measure competition
- Managers: Gain insights into variable costs and effectiveness of their decisions
Operating profit margin formula
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.
What is a good operating margin?
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.
How to increase the operating margin
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.
- Analyze category expenses. Companies can improve their operating margins by identifying key spendings from their business expense ledger and keeping these expenses in line with gross revenue.
- Create economics of scale. Identifying process consolidation opportunities is another great way to boost margin. This consolidation requires careful evaluation, analysis, and transformation of existing processes so that new processes generate more revenue.
- Trim operations waste. Conducting regular audits helps businesses identify lengthy production processes and control the use of raw materials. Minimizing operational lags with production process synchronization is key to business operation efficiency.
Operating margin vs. gross margin vs. net margin
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.
by Holly Landis
