Operating Margin

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DEFINITION of 'Operating Margin'

Operating margin is a margin ratio used to measure a company's pricing strategy and operating efficiency.

Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. It can be calculated by dividing a company’s operating income (also known as "operating profit") during a given period by its net sales during the same period. “Operating income” here refers to the profit that a company retains after removing operating expenses (such as cost of goods sold and wages) and depreciation. “Net sales” here refers to the total value of sales minus the value of returned goods, allowances for damaged and missing goods, and discount sales.

Operating margin is expressed as a percentage, and the formula for calculating operating margin can be represented in the following way:

Operating Margin

Operating margin is also often known as “operating profit margin,” “operating income margin,” “return on sales” or as “net profit margin.” However, “net profit margin” may be misleading in this case because it is more frequently used to refer to another ratio, net margin.

BREAKING DOWN 'Operating Margin'

Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each dollar of sales. Generally speaking, the higher a company’s operating margin is, the better off the company is. If a company's margin is increasing, it is earning more per dollar of sales.

For an example of how to calculate operating income, suppose that Company A earns $12 million in a year with $9 million of cost of goods sold and $500,000 in depreciation. Also suppose that Company A makes $20 million in sales during the same year, with $1 million worth of returns, $2 million in damaged and missing goods and $1 million in discounts. Company A’s operating margin for the year is then:

($12M - $9M - $0.5M) / ($20M - $1M - $2M - $1M) = $2.5M / $16M = 0.1563 = 15.63%

With an operating margin of 15.63%, Company A is earning about $0.16 (before interest and taxes) for every dollar of sales.

A company’s operating margin often determines how well the company can satisfy creditors and create value for shareholders by generating operating cash flow. A healthy operating margin is also required for a company to be able to pay for its fixed costs, such as interest on debt, so a high margin means that a company has less financial risk than a company with a low margin.

For example, if Company A has an operating margin of 4% on $10 million in net sales and Company B has an operating margin of 11% on $20 million in net sales, Company A may have a difficult time covering its fixed costs if business declines in a given year. Company B, on the other hand, has a comfortable buffer to account for hard financial times.

When determining operating margin, it is important to take into account the nature of the operating expenses you are incorporating into your calculations. Operating expenses are often considered to be either “fixed” or “variable.” Fixed operating expenses are expenses that remain steady over time, even as business activity and revenues change. Some examples of fixed expenses include rent paid for facilities and interest on debt, as these expenses are often at predetermined rates. Variable operating expenses, on the other hand, change with changes in business. One example of a variable operating expense is the cost of raw materials, as the total cost of raw materials will rise with increased demand and sales of manufactured goods.

Often, nonrecurring cash flows, such as cash paid out in a lawsuit settlement, are excluded from the operating margin calculation because they don't represent a company's true operating performance.

When calculating operating margin, expenses are also often designated as either “cash expenses” or “non-cash expenses.” Unlike cash expenses, non-cash expenses do not require a cash outlay. For example, for the sake of calculations, the cost of a piece of equipment expected to last ten years has its cost divided out over those ten years, with annual calculations during that period each taking into account 10% of the cost of the equipment. This distinction largely accounts for difference between operating income and operating cash flow.

Uses of 'Operating Margin'

Operating margin’s primary functionality, as mentioned above, is its ability to gauge how efficiently a company is operating, or how profitable it is. Yet, using it in different ways can elucidate certain things about a company or industry that a single operating margin for a company cannot.

For example, operating margin may be calculated for a period of a quarter or a year, which is useful in assessing a company’s operating history. A savvy investor may often track a company’s operating margin over time (perhaps over the past four, eight or twelve quarters) to determine if the company’s margin has historically been consistent or if growth in its operating margin is stable. For example, a company with a high operating margin in the current quarter but low operating margins during the previous seven quarters probably requires further attention. With its operating history, one may not necessarily rely on this high operating margin persisting in a stable way.

Operating margin can also help an investor take an even closer look at a company, as it can be used to analyze a particular project within a company, not only the company itself. Projects can vary widely in size, but operating margin may still be used to investigate a particular project or compare multiple projects within a company.

Limitations of 'Operating Margin'

Like any ratio that sets out to gauge a company’s performance and profitability, operating margin comes with an important set of limitations that a prudent investor would do well to consider.

For one, operating margin calculations do not account for the investment capital that got the company started in the first place. This is particularly important when considering young companies, as they may be working to recoup initial costs, an effort that will likely not be reflected in an operating margin.

Additionally, certain complications involving overhead costs may arise when attempting to calculate the operating margin for specific projects within a company. Many companies have overhead that is not tied to a single particular project, but rather to the entire company. One common example of such costs is salary costs for employees working at a company’s headquarters, which may oversee and provide support for all or many of a company’s projects.

Moreover, like all ratios used in ways similar to this one, operating margin should only be used to compare different companies when they operate in the same industry, and ideally when they have similar business models and revenue numbers as well. Companies in different industries may often have wildly different business models, such that they may also have very different operating margins, thereby rendering a comparison of their operating margins relatively meaningless.

For more information on this topic, check out Analyzing Operating Margins.

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