What Is Operating Margin?
Operating margin measures how much profit a company makes on a dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company’s operating income by its net sales.
- Operating margin is the profit a company makes on a dollar of sales after paying for variable costs but before paying any interest or taxes.
- To calculate the operating margin, divide operating income (earnings) by sales (revenues).
- Operating margin is a profitability ratio that shows how much profit a company makes from its core operations in relation to the total revenues it brings in.
- Earnings before interest and taxes (EBIT) is the same metric as operating income and can be used in calculating operating margin.
- Operating margin helps investors understand how a business makes money; if it is generating income primarily from core operations, or other means, such as investments.
- An increasing operating margin over a period of time indicates a company whose profitability is improving.
Calculating Operating Margin
Understanding Operating Margin
A company’s operating margin, also known as return on sales, is a good indicator of how well it is being managed and how risky it is. It shows the proportion of revenues that are available to cover non-operating costs, like paying interest, which is why investors and lenders pay close attention to it.
Highly variable operating margins are a prime indicator of business risk. By the same token, looking at a company’s past operating margins is a good way to gauge whether a company's performance has been getting better. Operating margin can improve through better management controls, more efficient use of resources, improved pricing, and more effective marketing.
In its essence, operating margin is how much profit a company makes from its core business in relation to its total revenues. This allows investors to see if a company is generating income primarily from its core operations or from other means, such as investing.
General Motors (GM) was a prime example of this. In the 1980s and 1990s, GM was making the bulk of its profits from financing cars as opposed to making and selling actual cars, its core operations. Therefore, its operating margins were very low. Since then, its automotive business generates more income than its financing business.
Calculating Operating Margin
The formula for operating margin is:
When calculating operating margin, operating earnings is the same as earnings before interest and taxes (EBIT). EBIT, or operating earnings, is revenue minus cost of goods sold and the regular selling, general, and administrative costs of running a business, excluding interest and taxes.
For example, if a company had revenues of $2 million, cost of goods sold of $700,000, and administrative expenses of $500,000, its operating earnings would be $2 million - ($700,000 + $500,000) = $800,000. Its operating margin would then be $800,000 / $2 million = 40%.
If the company was able to negotiate better prices with its suppliers, reducing its cost of goods sold to $500,000, then it would see an improvement in its operating margin to 50%.
Limitations of Operating Margin
Operating margin should only be used to compare companies that operate in the same industry and, ideally, have similar business models and annual sales. Companies in different industries with wildly different business models have very different operating margins, so comparing them would be meaningless. It would not be an apples-to-apples comparison.
To make it easier to compare profitability between companies and industries, many analysts use a profitability ratio which eliminates the effects of financing, accounting, and tax policies: earnings before interest, taxes, depreciation,?and amortization (EBITDA). For example, by adding back depreciation, the operating margins of big manufacturing firms and heavy industrial companies are more comparable.
EBITDA is sometimes used as a proxy for operating cash flow, because it excludes non-cash expenses, such as depreciation. However, EBITDA does not equal cash flow. This is because it does not adjust for any increase in working capital or account for capital expenditure that is needed to support production and maintain a company’s asset base—as operating cash flow does.