Gross margin and operating margin are two fundamental profit metrics used by investors, creditors, and analysts to evaluate a company's current financial condition and prospects for future profitability. The two margins differ in regard to the specific costs and expenses included in their calculations and the different purposes they serve in providing a company with information for analysis.
What Is Gross Margin?
Gross margin, also called gross profit margin, represents the percentage of total revenue a company has left over above costs directly related to production and distribution. The percentage figure is calculated by subtracting those costs from the total revenue figure and then dividing that sum by the total revenue figure. For gross margin, the higher the percentage, the more is retained on each dollar of sales by the company. On the other hand, if a company's gross margin is falling, it may look to find ways to cut labor costs, lower costs on acquiring materials or even increase prices.
As a simple example, a company with $100,000 in total sales and $65,000 in direct production-related costs has a gross margin of 35%. The gross margin shows the percentage of total sales a company has left over to cover all other costs and expenses while leaving an acceptable net profit.
What Is Operating Margin?
Operating margin additionally subtracts all overhead and operational expenses from revenues, indicating the amount of profit the company has left before figuring in the expenses of taxes and interest. For this reason, operating margin is sometimes referred to as EBIT, or earnings before interest and tax.
Operating margin is calculated with the same formula as gross margin, simply subtracting the additional costs from revenue before dividing by the revenue figure. Operating expenses include items such as wages, marketing costs, facility costs, vehicle costs, depreciation, and amortization of equipment. Analyzing a company’s historical operating margins can be a good way to tell if recent earnings growth in the business is likely to last.
Comparing Gross Margin and Operating Margin
There are plenty of similarities between gross margin and operating margin. Both are representations of how efficiently a company is able to generate profit by expressing it through a per-sale basis. Higher margins are considered better than lower margins. Both can be compared between similar competitors, but not across different industries.
Since operational costs such as salaries and advertising are more easily adjusted than the usually fixed costs of production, companies scrutinize their operating expenses for ways to cut costs efficiently, in an effort to increase their profit margins. The operating margin calculation, as it is done without including costs of financing or tax expenses, also provides a company with a clear indication of whether it has a solid enough profit position to take on additional financing to expand.
Operating margin is a more significant bottom-line number for investors than gross margin. Comparisons between two companies' operating margins with similar business models and annual sales are considered to be more telling.
Gross profit margin is almost always higher than the operating margin because there are fewer costs to subtract from gross income. Gross margin offers a more specific look at how well a company is managing the resources that directly contribute to the production of its salable goods and services.