Operating Margin

Loading the player...

What is an '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.

RELATED TERMS
  1. Profit Margin

    Profit margin is part of a category of profitability ratios calculated ...
  2. Operating Cash Flow Margin

    A measure of the money a company generates from its core operations ...
  3. Operating Income

    The amount of profit realized from a business's operations after ...
  4. Marginal Profit

    Marginal profit is the profit earned by a firm or individual ...
  5. Operating Ratio

    A ratio that shows the efficiency of a company's management by ...
  6. Margin Debt

    1. The dollar value of securities purchased on margin within ...
Related Articles
  1. Investing

    A Look At Corporate Profit Margins

    Take a deeper look at a company's profitability with the help of profit margin ratios.
  2. Investing

    Analyzing Operating Margins

    Find out how to put this important component of equity analysis to work for you.
  3. Investing

    Gross, Operating and Net Profit Margins

    A company’s income statement includes the company’s gross, operating and net profits.
  4. Investing

    Calculating Operating Ratio

    An operating ratio compares a company’s operating expenses to its net sales.
  5. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  6. Investing

    What’s a Good Profit Margin for a New Business?

    Surprisingly, the younger your company is, the better its numbers may look.
  7. Investing

    What's a Good Profit Margin for a Mature Business?

    How to determine if the amount you clear dovetails with the competition.
  8. Investing

    Operating Leverage Captures Relationships

    Find out how fixed and variable costs interact to shed new light on old companies.
  9. Investing

    What is Net Margin?

    The ratio of net profits to revenues for a company that shows how much of each dollar earned by the company is translated into profits.
  10. Investing

    How Gross Margin Can Make or Break Your Startup

    Find out how your startup's gross margin can impact your business, including why a mediocre margin may spell disaster for a budding business.
RELATED FAQS
  1. What is a good operating margin for a business?

    Read about what it means to have a good operating margin and why that answer depends heavily on competitive and historical ... Read Answer >>
  2. What does operating margin measure?

    Learn about why investors look to a company's operating margin, or return on sales, as a signal of both efficiency and profitability. Read Answer >>
  3. Why does operating profit exclude interest revenues and expenses?

    Understand the purpose of examining a company's operating profit margin and why interest revenues and expenses are not included ... Read Answer >>
  4. What is the difference between operating margin and profit margin?

    Understand the difference between operating margin and profit margin in relation to evaluating a company's profitability ... Read Answer >>
  5. What is considered a healthy operating profit margin?

    Understand the concept and significance of operating profit margin, and learn what analysts consider to be a healthy margin ... Read Answer >>
  6. What types of financial margins should investors pay the most attention to before ...

    Learn what types of financial margins, such as profit and cash margins, an investor should pay the most attention to before ... Read Answer >>
Hot Definitions
  1. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  2. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  3. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  4. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  5. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  6. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
Trading Center