Operating Margin: Definition, Calculation And More
Apr 17, 2023 | 8 min read | Leave a comment
The operating margin is an important metric that determines how profitable a business is. It is widely regarded as one of the most significant accounting metrics for operational effectiveness.
Analyzing your business’ previous operating margins is a useful technique to see whether or not its performance has improved.
Therefore, any business needs to learn and analyze this metric carefully. With our blog, you will find all the information, including the operating margin definition, its pros and cons, and the formulas to calculate it.
What Is Operating Margin?
Operating margin refers to a profitability ratio that shows how much profit a business makes on sales after deducting variable expenses of production such as salaries and raw materials but before deducting interest and tax.
An operating margin will depend on your business sector. It is because varied industries have varied capital structures, levels of competition, and scale efficiency.
A high operating margin indicates that your business is effective in its operations and adept at converting sales into profits. Better managerial controls, more effective resource usage, better pricing, and more successful marketing can be helpful in increasing operating profit.
How to Calculate Operating Margin?
The operating margin of a business is determined by dividing operating income by revenue. To make comparisons easier between previous periods and with competitors in the same industry, the operating margin is expressed as a percentage. The operating margin formula is:
|Operating Margin = (Operating Income / Revenue) x 100%|
For your information:
- Operating Income, also referred to as EBIT (Earnings Before Interest & Taxes), represents a business’ profits following the deduction of operating expenses and costs of goods sold (COGS) from the total gross income but before accounting for interest and taxes.
- Operating Expenses, aka selling, general, and administrative (SG&A) expenses, are costs incurred by a business on a daily basis for its operations. In other words, costs are related to routine company activities. Some instances of operating expenses are: Advertising and marketing, Maintenance and repairs, Rent, Research and Development, Travel, Utilities, etc.
- Revenue is often referred to as net sales generated from selling products and/or services to customers.
Take a look at Apple’s statements of operations! You can find the total net sales in the period of 3 months ending on June 25, 2022 at $82,959 and the operating income in that same period at $23,076.
Applying these figures to the formula, we have an operating margin of ($23,076 / $82,959) x 100% = 27.8%.
The Importance Of Tracking Operating Margin
The operating margin is a valuable indicator of a business’s overall profitability from operations. It is crucial in assessing the financial health of a business. So, tracking the operating profit margin can help you to:
- Find out how much money you are making per sale in order to better comprehend the profitability of your business operations.
- Monitor the revenue you generate from sales before taxes and other direct and indirect costs.
- Check whether or not you have enough money to invest in future proposals for business growth.
- Determine if you might require a cash infusion in the future.
- Performance benchmarking to compare your business to other competitors in the industry
Moreover, a business with a healthy operating margin will be more enticing to new investors and creditors. It is because the higher the margin you have, the less financial risk you will face.
Your business’ good operating margin means you will generate value for shareholders and continuous loan servicing for lenders without the risks of financial loss.
What Are Some Limitations Of Operating Margin?
Though operating margin is a valuable metric to measure your business’ profitability, it has some flaws that prevent you from getting a full picture of your entire business.
- Reevaluating over time is required: This is not a metric you can look at and use to judge how profitable a business is immediately. To properly understand how the business is performing and whether they are increasing their profitability, you need to compare the operating margin to prior results.
- Not an indicator of value or cash flow: Operating margin is merely an accounting metric and is, therefore, not a reliable indicator of economic value or cash flow. The operating margin does not account for non-cash costs like depreciation and amortization, stock-based compensation, capital expenditures, or changes in working capital, despite the fact that cash flow is the real generator of business value. As a result, it actually does not convey the complete value of a business.
- No interest or taxes are taken into account: A business may have a high operating margin, but if interest costs are out of control and tax costs are significantly reducing the net profit margin, the operating margin does not precisely reflect the profitability of the business.
- Not an apples-to-apples comparison across industries and business models: Operating margins are significantly variable for businesses in different industries with very different business models, thus, comparing them would be pointless.
- Not sufficient as a standalone metric: With all the aforementioned reasons, the operating margin is insufficient on its own to assess a business’s overall performance. Instead, it is only useful as an add-on metric to evaluate a certain area of a business.
|To get a full and clear picture of your financial performance and make decisions that truly matter, you have to view your operating margin side by side with other crucial metrics like revenue, profits & losses, customer lifetime value, CAC:LTV ratio, etc.|
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Operating Margin vs Other Margins
As you have learned the operating margin’s limitations, you must combine other necessary metrics to gain a better understanding of your business’s financial status. Net margin and gross margin are those metrics that you can pay attention to in addition to the operating margin.
- Gross margin: refers to the profit a business makes on its COGS. To put it another way, it shows how well you employ labor and resources during the production process.
- Net margin: refers to the net profits produced across all business divisions while taking into account all expenses and accounting charges, such as taxes and depreciation. That means this metric compares sales with net income. It shows how well you are managing your business.
The key differences between Net margin vs Gross margin vs Operating margin are:
- Net margin: The most complete way to calculate profitability, which accounts for all expenses related to a sale.
- Gross margin: COGS is all that is included when calculating gross margin; overhead, fixed costs, interest charges, and taxes are all excluded.
- Operating margin: All operating costs are included in the operating margin, while non-operating costs are not.
Yet, the picture of your financial status and profitability will be better and more full if you combine these 3 margins. These are the 3 key variables that you can consider when analyzing your revenue-generating activities.
When taken as a whole, these data provide a comprehensive understanding of your business operations in relation to your product.
Frequently Asked Questions
What is a good operating margin?
Although the operating margin will vary greatly by industry, it is ideal for businesses to have at least a 15% margin. Anyway, it could be fair to say that the only good operating margin is one that is increasing over time because higher operating margins are generally preferable to lower operating margins.
How is the operating margin calculated?
Your operating margin can be calculated by dividing your business’ operating income by its revenue and expressed as a percentage.
What is profit margin vs operating margin?
The profit margin represents the portion of revenue that your business keeps after all costs have been paid while the operating margin shows the percentage of profit produced by operating operations.
The main difference between the two margins is the operating margin’s exclusion of non-operating activities, which often include financial transactions like interest income and interest expense.
Is operating margin and EBIT the same?
EBIT stands for “Earnings Before Interest and Taxes” and is not the same as the operating margin. Instead, the operating margin is calculated using EBIT as one of the values.
Overall, you can accurately and regularly monitor your business’ profitability from core operations with current insights by calculating the operating margin.
This metric is not only essential for daily operations and long-term planning but also when trying to attract investors or financial institutions.
Now that you have learned the importance of the operating margin and how to calculate it, you can start analyzing and proposing plans for your business growth.
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