Operating margin

Operating margin

Investors and analysts can better understand a company’s financial health and make more informed investment decisions by focusing on the operating margin. In summary, operating margin is an important metric that provides valuable insights into a company’s profitability and financial performance. 

What is operating margin? 

Operational margin, commonly referred to as return on sales, is a fundamental profitability statistic that measures revenue after subtracting operating costs. After paying for variable manufacturing expenses like labour and raw materials but before paying the interest or taxes, this margin calculates the profit an organisation generates on each dollar of sales. 

The income statement of a company’s regular quarterly and yearly reports with the Securities and Exchange Commission has a line item for operating income, a significant component of operating margin. Operating income is shown above income taxes and expenses but beneath operating costs.

Understanding the operating margin 

Operating income is also called EBIT, or earnings before interest and taxes. Let’s understand operating profit first before discussing operating margin, often known as operating profit margin.  

Operating profit = revenue – the cost of goods sold and operating expenses (typically includes selling, general, and administration costs, sales and marketing, research and development, and depreciation and amortisation) 

Operating margins with high variability are a key sign of company risk. Likewise, examining a company’s historical operating margins can help determine if its performance has improved. The operating margin may be raised by improving managerial controls, resource usage efficiency, pricing, and marketing effectiveness. 

Whether monthly, quarterly, or yearly, companies may calculate operating margins throughout any period. Companies frequently calculate the operating margin for certain company divisions and product categories. In doing so, they can contrast the profitability of various corporate divisions. 

Operating margin formula 

                                  operating income 

Operating margin = ————————————— x 100 

                                              revenue 

Let us look at the following example. If a corporation had US$2 million in revenue, US$800,000 in COGS, and US$600,000 in administrative expenses, its operating profits would be US$2 million – (US$800,000 US$ + US$600,000 US$) = US$600,000.  

Thus, it would have an operating margin of US$600,000 / US$2,000,000 x 100, i.e., 30%. 

The company’s operating margin would increase to 40% if it could lower its COGS to US$600,000 by negotiating better rates with its vendors. 

Usage of operating margin 

Investors and analysts use the operating margin to evaluate a company’s financial health. Using an operating margin can help investors determine whether a company is generating enough revenue to cover its operating expenses and earn a profit.  

 However, operating margins will vary by industry; thus, comparisons should be conducted with comparable companies in similar sectors. 

 Identifying particular areas for improvement would be possible by looking at a breakdown of operational expenses. For instance, a spike in general, selling, and administrative costs in one quarter can prompt senior management to investigate the causes of the rise and look for strategies to keep costs in check in the following periods. 

 A high operating margin indicates that a company efficiently manages its expenses and generates profits. In contrast, a low operating margin may indicate a company is struggling to cover its costs. Operating margins can help companies identify areas to reduce costs and improve profitability.  

 Overall, using operating margins is essential for investors and companies to evaluate financial performance and make informed decisions. 

Operating margin/profit drawbacks 

While the operating margin is an essential tool for evaluating a company’s financial health, there are drawbacks to relying solely on the operating margin as a performance indicator.  

One significant drawback is that it does not account for non-operational expenses, such as interest or taxes. Therefore, a company with high non-operating expenses or debt may have a lower operating margin.  

Additionally, the operating margin does not consider a company’s revenue growth potential, which is crucial for long-term success. To understand a company’s financial performance, it is important to consider operating margin alongside other financial metrics, such as net income, cash flow, and return on investment. 

Frequently Asked Questions