Running a successful business requires strong planning, optimal investment, a required workforce, and dedication. But how will you know your financial health? The answer is operating margins.
Is this term unknown to you? Then, go through our words. You will be able to uncover the meaning of operating margin, its formula, and the process of calculating it.
What Is Operating Margin?
The operating margin represents the profit that the company makes after expenditure on variable costs and before taxation. It is defined as the proportion of operating income to net revenue or net sales.
The operating margin is calculated by dividing operating income by net sales and is represented in percentage form. A high operating margin indicates a company’s good performance, thus representing a business’s financial health.
The other alternative names for operating margin are operating income margin, EBIT (Earnings Before Interest and Taxes) margin, operating profit margin, or return on sales.
Investors and lenders always pay close attention to operating profit margins, representing the proportion of revenues available to cover non-operating costs.
Important Financial Terms Used in Operating Margin
We have already discussed operating margins. Additionally, you must be aware of crucial financial terms. Here are the crucial financial terms that are useful in operating profit margins.
- Revenue – It refers to the net sales that companies generate after selling products or services.
- Cost of Goods Sold (COGS) – This is the cost directly associated with the company’s core revenue model. It covers labor, materials, and overhead costs.
- Gross Profit – Gross Profit = Revenue – COGS (Cost of Goods Sold)
- Operating Expenses (SG&A) are indirect costs that are not directly related to the company’s revenue model.
- Operating Income (EBIT) – Operating Income = Gross Profit – Operating Expenses
How to Calculate Operating Margin?
After defining the operating margin, we now see how to calculate it. Operating margin assesses a company’s profitability from its primary business operations. It shows the percentage of revenue a company gets after subtracting all operating expenses. So, we calculate the operating profit margin using the formula explained below.
Operating Margin Formula
Operating margin is defined as the ratio of operating earnings to revenue. Therefore, to calculate the operating margin, we divide the company’s operating income by its net revenue. The operating margin formula is as follows:
Operating Margin = Operating Earnings or Operating Income x 100/ Revenue
Operating earnings (operating income) = Total Revenue – (cost of goods sold + operating expenses)
Let’s understand this formula through an example of an operating margin. Suppose a company has a revenue of $100,000 with expenses of $2,000 and $1,000. Then, its operating income will be as follows:
Operating Earnings = $100,000 – ($2,000 + $1,000)
= $97,000
Now, the total operating margin calculation as per the above formula:
$97,000 x 100/ $100,000
= 97%
A higher operating margin indicates good business performance, which means the company is performing well.
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What Is the Significance of Operating Margin?
Operating margin is a key financial metric that contributes to the optimal financial actions of a business. The following are the major points presenting the value of the operating margin:
1. Helps in Deciding on the Price
Operating margin is a helpful metric for professionals to use when deciding on a price. When they find a low operating margin, they can modify prices according to satisfactory performance.
2. Indicate Business Efficiency
Professionals can define business efficiency through the operating margin. A high operating margin signifies greater profitability for the company and shows that it is properly managing its costs.
3. Benchmarking Against Competitors
Professionals can easily evaluate their business performance by comparing the operating margin with their industry peers.
4. Supports Business Growth & Expansion
A good operating margin specifies a company’s good cash flow. This indicates that the company is capable of reinvesting in equipment and marketing.
Operating Margin vs Gross Margin vs Net Margin: Check the Difference
Gross margin, operating margin, and net margin are three essential metrics for measuring profitability. However, these three terms differ in their definitions, formulas, and financial implications. Let’s define the differences in the tabular form below:
| Key Points | Operating Margin | Gross Margin | Net Margin |
|---|---|---|---|
| Definition | Operating margin is the percentage of revenue remaining after subtracting all operating expenses (operational cost and cost of goods sold). | Gross margin is the percentage of revenue left after subtracting COGS (Cost of Goods Sold) | Net margin or net profit margin measures the percentage of revenue that remains after subtracting all the expenses, including interest, operating expenses, and taxes. |
| Formula | (Revenue – COGS – Operating Expenses)/Revenue * 100 | (Revenue – COGS)/Revenue * 100 | (Revenue – All Expenses)/Revenue * 100 |
| Indicate | Operating margin indicates the company’s ability to manage its core operations and operational costs. | It reflects the company’s ability to manage its core production and purchasing costs. | It indicates the amount of a company’s profit made after accounting for all costs and every revenue. |
How Companies Can Refine Their Operating Profit Margin?
The following strategies work well to refine a business’s operating margin. Let’s understand each one.
1. Cutting Down the Cost
High costs and expenses impact the operating margin. Therefore, companies can reduce their product or service costs and other unnecessary expenses. This can significantly improve operating margins. However, there should be no quality compromise.
2. By Managing Inventory Efficiently
Price reductions can occur when there is a high stock of products or a surplus. Therefore, managing inventory is necessary to refine the company’s profit margin.
4. Developing Sales Strategies
Sales strategies include promoting and marketing products and developing pricing strategies, which are important for customer satisfaction. Additionally, they increase revenue, which ultimately impacts the operating profit margin.
5. Removing Low Performing Goods
Sometimes, certain products do not perform well on the market. A company can remove or upgrade those low-performing goods according to the current industrial trend, which will positively impact profits.
6. Encourage Workers
When your staff is capable of selling products efficiently, your profit margin will automatically improve. Company professionals can arrange and conduct training for staff and give them full product knowledge.
What Are the Limitations of Operating Margin?
Operating margins have some limitations. Therefore, while considering the positive aspects of the operating profit margin, one should also be aware of its limitations.
The first limitation is that comparing companies is only possible when they are operating in the same industry. Operating margins vary from industry to industry, and therefore, two companies in different industries will have different operating margins.
The operating margin excludes taxes, interest expenses, and one-time costs. It only accounts for revenue and operating costs. Impairments and one-time restructurings are also not available in the operating margin.
The operating profit margin’s major focus is always on past statistics and performance. It never covers the upcoming growth estimate from a future point of view, and it doesn’t show the effect of current cost-cutting measures.
Industries With High and Low Profit Margin
Some industries have high or low profit margins, depending on the need. Let’s consider a high profit margin.
Companies that do not spend much on development, overhead, marketing, or production and generate sales simultaneously often come from high-profit margin sectors. The best example is a SaaS (Software as a Service) product-based company because it invests little in its scalability. The monthly and annual subscription model provides a steady cash flow.
Operations-intensive businesses have lower profit margins. For instance, an auto parts company will have approximately 4.5% operating margins. This business also faces intense competition.
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Verdict
The operating margin reflects the output of the company’s core business. Professionals can utilize operating margins to evaluate the business’s health and the approach to managing it well. Therefore, operating margin is a valuable term, and professionals must not ignore it.
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Jayanti Katariya is the founder & CEO of Moon Invoice, with over a decade of experience in developing SaaS products and the fintech industry. He holds a degree in engineering. Since 2011, Jayanti's expertise has helped thousands of businesses, from small startups to large enterprises, streamline invoicing, estimation, and accounting operations. His vision is to deliver top-tier financial solutions globally, ensuring efficient financial management for all business owners.
